Lists

Question 1

Benefits of the Risk Management Process (8)

Answer 1

1. Avoid surprises
2. React more quickly to emerging risks
3. Improves stability (I.e. reduce earnings volatility) and quality of business
4. Improve growth and returns by exploiting opportunities in the market
5. Improve growth and returns through better management and allocation of capital
6. Identify their aggregate risk exposure and assess interdependencies.
7. Integrate risk into business processes and strategic decision making
8. Give shareholders in their business confidence that the business is well managed

Question 2

Advantages of Enterprise Risk Management (5)

Answer 2

1. Allowance for the benefits of DIVERSIFICATION
2. Provides insight into the areas with undiversified risk exposures or too much risk concentration of risk, where the risk need to be transferred or sufficient capital set aside to cover
3. Ensures efficient CAPITAL USE across the group
4. Enables the company to take advantage of OPPORTUNITIES to add value
5. Understanding risk better across the whole enterprise which allows the company to take GREATER RISKS in order to increase returns

Question 3

Steps to achieve an effective identification of risk facing a project (7)

Answer 3

1. Start with a HIGH-LEVEL PRELIMINARY RISK ANALYSIS - confirm whether the project is too high risk to continue.
2. Hold a BRAINSTORMING session of project EXPERTS and senior internal and external people- to identify all project risks, both likely and unlikely… and their upsides and downsides.
   — discuss the risks and their interdependency
   — to attempt to place a broad initial evaluation on each risk, both for frequency or occurrence
   — generate initial mitigation options
3. Use a DESKTOP ANALYSIS to supplement the above- similar projects should be researched.
4. Set out all the identified risks in a RISK REGISTER …with cross references to other risks where there is interdependency.
5. A RISK MATRIX could also be used.
6. RISK CHECKLIST or
7. RISK CLASSIFICATION categories could be used to help gain breadth of risk identification.

Question 4

Capital needs: companies (6)

Answer 4

1. Deal with financial consequences of adverse events
2. Provide a cushion against fluctuating trading volumes
3. Financial expansion
4. Working capital –>finance stock and work-in-progress
5. Start-up capital–> obtain premises, hire staff, purchase equipment
6. Take advantage of investment opportunities

Question 5

Capital Management Tools

Answer 5

1. Reinsurance
2. Financial reinsurance
3. Securitisation
4. Subordinated debt
5. Banking products
   a. Liquidity facility
   b. Contingent capital
   c. Senior unsecured financing
6. Derivatives
7. Equity capital
8. Internal restructuring
   a. Merging funds
   b. Reducing writing new business
   c. Changing assets
   d. Weakening the valuation basis
   e. Deferring surplus distribution (bonuses)
   f. Retaining profits

Question 6

Benefits of securitisation (6)

Answer 6

1. Makes an untradable asset tradable
2. Raise money that is linked directly to the CF receipts that it anticipates receiving in the future
3. Alternative source of financing to issuing “normal” secured/unsecured bonds
4. A way of passing the risk in the assets to a third party, removing them from the balance sheet and reducing required capital
5. A way of effectively SELLING EXPOSURE to what may be an otherwise unmarketable pool of assets
6. Change RISK PROFILE

Question 7

Aims of regulation (5)

Answer 7

1. Correct market inefficiencies and to promote efficient and orderly markets
2. Protects consumers of financial products
3. Maintain confidence in the financial system
4. Help reduce financial crime
5. To limit the likelihood and potential cost of failures of financial companies and to limit the need for the government to step in as a lender of last resort

Question 8

Indirect costs of regulation (5)

Answer 8

1. Alteration in CONSUMER BEHAVIOUR, who may be given a false sense of security for their own actions and/or reduce sense of responsibility
2. Undermining the sense of professional responsibility among INTERMEDIARIES and advisors
3. Reduction in SELF-REGULATION by the market (reduction in consumer protection mechanisms developed by the market itself)
4. Reduced product INNOVATION
5. Reduced COMPETITION

Question 9

Functions of a regulator (8)

Answer 9

SERVICES

S- Setting SANCTIONS
E- ENFORCING regulations
R- REVIEWING and influencing government policy
V- VETTING and registering firms and individuals authorized to conduct certain types of business
I- INVESTIGATING suspected breaches
C- Supervising the CONDUCT of financial businesses, and taking enforcement action where appropriate
E- EDUCATING consumers and the public
S- SUPERVISING the prudential management of financial organizations

Question 10

Mitigation tools for information asymmetries (5)

Answer 10

1. Disclosure of information in plain language
2. Chinese walls- policies and procedures intended to prevent the misuse of inside information in securities trading by limiting the availability of material, nonpublic information to departments of the firm that might misuse such information.
3. Cooling off periods, price controls and regulation of selling practices
4. Customer legislation on unfair contact terms and TCF
5. Whistle blowing by actuaries if they believe the client is treating customers unfairly

Question 11

Mitigating tools for maintaining confidence (5)

Answer 11

1. Check capital adequacy of providers
2. Ensuring practitioners are competent and act with integrity
3. Industry compensation schemes
4. Ensuring orderly and transparent markets
5. Stock exchange requirements

Question 12

Forms of regulation

Answer 12

1. Prescription regimes- details rules as to what may or may not be done
2. Freedom of action- freedom of action but with rules on publicity so that third parties are fully informed about what is being provided
3. Outcome-based regimes- the regulator can allow freedom of action but prescribe what outcomes will be tolerated

Question 13

Aims of climate change related financial regulations

Answer 13

BAD ROSE
B- consider climate risks in Business decisions making and strategic planning
A- adopting a consistent and reliable means of Assessing, pricing, and managing climate-related risks
D- effectively Disclosure and report on climate related risks and opportunities
R- incorporate financial risks from climate change into existing Risk management processes
O- consider the impact of climate risks on the ability to meet Obligations towards policyholders and other key stakeholders
S- use Scenario analysis to inform risk identification and to estimate the impact of financial risks arising from climate change
E- incorporate ESG factors into investment management decisions

Question 14

Reasons for calculating individual provisions (11)

Answer 14

Please Stop Imagining Me Dancing For Bank. I Don’t Dance Exotically.

1. Determining the value of liabilities for Published accounts
2. Determining Supervisory Solvency
3. Determining the value of liabilities for Internal management accounts
4. Valuing the provider for Merger and acquisition (or transferring liabilities)
5. Determining whether Discretionary benefits can be awarded
6. Setting Future contribution levels for benefit schemes
7. Valuing Benefit improvement for a pension scheme
8. Influencing Investment strategy
9. Calculating Discontinuance benefits
10. Providing Disclosure information to beneficiaries
11. To provide the Expected credit losses for a bank

Question 15

Purpose for calculating global provisions (3)

Answer 15

1. Act as additional protection against insolvency
2. Cover risks, both financial and non financial, that cannot necessarily be attributed to individual contracts
3. Reflect the degree of mismatching of assets and liabilities

Question 16

Factors to consider on whether to buy or create a new model (5)

Answer 16

1. Level of accuracy required
2. The in-house expertise available
3. Number of times model is to be used
4. Desired flexibility of the model
5. The cost of each option

Question 17

Operational requirements of a model (8)

Answer 17

1. Well documented
   — key assumptions are understood
   — team members can also run the model
2. Easily communicable
3. Sensible joint behavior of model variables
4. Capable of independent verification
   — One can expect the peer reviews of the bases from time to time
5. Not be overly complex or time consuming
6. Be capable of development and refinement
7. Capable of being implemented in a range of ways
8. Have an appropriate time period between projected cash flows, balancing the reliability of the output with the speed of running the model

Question 18

Advantages of Voluntary codes of conduct (2)

Answer 18

Drawn up by the financial services industry itself
1. Reduced cost of regulation
2. Rules are set by those with the greatest knowledge of the industry

Question 19

Disadvantages of Voluntary codes of conduct (2)

Answer 19

Drawn up by the financial services industry itself
1. Greater incentive to breach the voluntary code
2. Vulnerable to lack of public confidence or to the few “rogue” operators refusing to co-operate, leading to the breakdown of the system

Question 20

Advantages of self-regulation (4)

Answer 20

Organised and operated by the participants in a particular market without government intervention
1. It is not mandatory so a company can apply the aspects that are sensible for that company.
2. System is implemented by the people with the greatest KNOWLEDGE of the market and the greatest INCENTIVE to achieve the optimal cost-benefit ratio (tends to set standards which are achievable and, if followed, should result in a well-run company)
3. Should be able to RESPOND RAPIDLY to changes in market needs
4. EASIER TO PERSUADE firms and individuals to co-operate with a self-regulatory organisations than with a government bureaucracy

Question 21

Disadvantages of self-regulation (3)

Answer 21

1. The closeness of the regulator to the industry because there is a danger that the regulator accepts the industries point of view and is less in turn with the views of third parties –> WEAKER REGIME (May not be truly independent to the detriment of the consumers)
2. Low public confidence
3. Inhibits new entrants to a market

Question 22

Advantages of Statutory regulation (3)

Answer 22

1. Less open to abuse
2. Commands greater public confidence
3. Regulatory body may be able to be run efficiently if economies of scale can be achieved through grouping its activities by function rather than type of business

Question 23

Disadvantages of Statutory regulation (3)

Answer 23

1. More costly
2. Inflexible
3. Outsiders (not market participants) may impose rules that are unnecessarily costly and may not achieve the desired aim

Question 24

Types of regulatory regimes (5)

Answer 24

1. Unregulated markets
2. Voluntary code of conduct
3. Self-regulated
4. Statutory regulation
5. Mixed

Question 25

3 main principles of insurance

Answer 25

1. Insurable interest
2. Pre-funding
3. Pooling of risk

Question 26

Major roles played by the state in relation to retirement benefits (6)

Answer 26

1. Direct provision of benefits
2. Sponsoring of the provision of benefits
3. Provision of financial incentive
4. Education
5. REGULATE to encourage or compel benefit provision
6. REGULATION providers of benefits (regulate bodies providing benefits and with custody of funds)

Question 27

Reasons that an employer would sponsor benefit provision (6)

Answer 27

1. Encouraged or compelled by the government
2. Attraction and retention of good quality staff
   — may want to offer benefits at least as good as key competitors
3. A desire to look after employees and their dependents
4. May want to reward loyal or key staff, and care for those in need
5. To pool expenses and expertise
6. The employer may be part of a multi-employer scheme that provides benefits

Question 28

Reasons for an individual to finance their own benefit provision

Answer 28

1. Encouraged or compelled by the state or their employer
2. The individuals personal preferences

Question 29

Types of underwriting for Healthcare products (5)

Answer 29

1. Full medical underwriting
2. Moratorium underwriting
3. Medical History Disregard (MHD)
4. No worse terms
5. Continued Personal Medical Exclusion (CPME)

Question 30

Reimbursement mechanisms for Healthcare products (4)

Answer 30

1. Fee-for-service
2. Negotiated fee-for-service
3. Global fee
4. Capitation

Question 31

Types of cash on deposit instruments

Answer 31

1. Call deposits
2. Notice deposits
3. Term deposits

Question 32

Players of money market instruments (3)

Answer 32

1. Clearing banks
2. Central Bank
3. Other financial institutions and non financial companies

Question 33

Types of money market instruments (4)

Answer 33

1. Treasury bills
2. Local authority bills
3. Bills of Exchange and Commercial paper
4. Certificate of deposit

Question 34

Reasons for holding cash on deposit and money market instruments (9)

Answer 34

A. LIQUIDITY
1. Meet short-term commitments (ideal match by term for the liability)
2. Because outgo is uncertain (won’t have to sell assets at depressed prices)
3. To be ready to take advantage of other investment opportunities.
4. Because the institution has received funds which are awaiting investment in some other category (recent cashflow)
5. The institution needs to protect the monetary value of assets (surplus assets might be low, a risk averse board or shareholder might want to protect the available assets by investing in the low-risk assets)
B. ECONOMIC CIRCUMSTANCES (Only attractive to an investor if they anticipated event BEFORE the market as a whole allows for them in the price of investments)
If they expect:
1. Rising interest rates (which might cause other assets to fall)
2. Economic recession (with a fear that equity and possibly bond prices will fall)
— Fears that government borrowing will increase —> larger supply a fixed interest bonds —> decrease price of these bonds
3. Domestic currency to weaken (makes overseas holdings attractive)
4. General economic uncertainty

OTHER
1. Risk averse
2. Worried about risk of default in other securities
3: wants diversification

Question 35

Reasons why it is inappropriate to hold a high proportion of cash on deposit and money market instruments (5)

Answer 35

1. Gives a lower expected return compared to other assets
2. May not match liabilities
3. Short-term interest rates move broadly in line with price inflation. However, money market instruments are not a good match if an investor has real liabilities linked to some other index.
4. Too large a proportion would result in a lack of diversification.
5. There may be a limited supply of money market instruments available.

Question 36

Shares are grouped by industry because: (2)

Answer 36

1. Its PRACTICAL for analysts to specialise in one area
2. The share price of companies in the same sector tend to be CORRELATED

Question 37

Its practical for analysts to specialise in one area (for equity) because (5):

Answer 37

1. The FACTORS affecting one company within an industry are likely to be relevant to other companies in the same industry
2. Much of the information for companies in the same industry will come from a COMMON SOURCE and will be presented in a similar way…
   … which makes it easier to stay informed on a specific sector
3. No one analyst can expect to be an expert in all areas, so specialisation is appropriate
4. The grouping of equities according to some common factor gives STRUCTURE to the DECISION-MAKING PROCESS. It assists in portfolio classification and management
5. Certain industries require specific EXPERTISE to value which may not be part of every analysts skillset

Question 38

Share prices in the same sector are correlated because such companies: (4)

Answer 38

1. Use the same RESOURCES and so have similar input costs
2. SUPPLY to the same markets and so are similarly affected by changes in demand
3. Similar FINANCIAL STRUCTURES, and so are similarly affected by changes in interest rates
4. Will be influenced by the same ECONOMIC and SOCIAL factors

Question 39

Factors of prime property (6)

Answer 39

Property that is most attractive to investors is called “Prime”
1. Location
2. Age and condition
3. Quality of tenant
4. The number of comparable properties available to determine the rent at the rent review and for valuation purposes
5. Lease structure
6. Size

Question 40

Disadvantages of direct property investment (6)

Answer 40

1. Size -properties are too big for most investors to afford
2. Lack of diversification
3. Unmarketable
4. Valuation -values are never known until sale… do not know the investment performance of the asset
5. Expertise needed
6. Maintenance costs

Question 41

Forms of indirect property investment (3)

Answer 41

1. Pooled property funds
2. Property companies shares
3. Listed JSE REITs (Real Estate Investment Trusts)

Question 42

Reasons why companies distribute profits by buying back shares issued to their investors (4)

Answer 42

1. May have EXCESS CASH that it cannot use profitably, so it decides to return it to the shareholder
2. Excess cash may only have been earning a deposit rate of interest, less than the return earned on the company’s other assets. Disposing of this cash should therefore IMPROVE THE EARNINGS PER SHARE for the remaining shares
3. TAX EFFICIENT means of returning capital gains more favorable than that of dividends
4. The company may want to CHANGE ITS CAPITAL STRUCTURE from equity financing to debt financing

Question 43

Key features of investment trusts (7)

Answer 43

1. Stated investment objectives
2. Key parties involved are the board of directors, investment managers and shareholders
3. Investors buy shares in an investment trust company, which are priced by supply and demand
4. Share price often stands at a discount to NAV per share
5. The funds are closed-ended
6. Governed by company law
7. Gearing is allowed

Question 44

Key features of unit trusts (6)

Answer 44

1. Stated investment objectives
2. Key parties involved are trustees, the management company and unitholders
3. Investors buy units in a unit trust, which are priced at NAV per unit
4. The funds are open-ended
5. Governed by trust law
6. Limited power to use gearing

Question 45

Differences between closed-ended and open-ended funds (8)

Answer 45

In a closed-ended scheme, once the initial tranche of money has been invested, the fund is closed to new money. To invest after launch, you will have to buy shares from a willing seller
In an open-ended scheme, managers can create or cancel units in the fund as money is invested or disinvested.
1. Marketability
-investments in closed ended funds are often less marketable than the underlying asset
-marketability of investment in open-ended funds is guaranteed by the managers
2. Gearing
-closed ended funds can gear —> extra volatility
-open ended funds have limited power to gear
3. NAV
- it may be possible to buy assets at less than the NAV in a closed-ended funds
4. Volatility
-Shares in closed ended funds are more volatile than the underlying assets because the size of any discount to the NAV can change
-the volatility of units in an open-ended fund should be similar to that of the underlying assets
5. Expected return
- increased volatility of closed ended funds implies a higher expected return
6. Uncertainty
-there may be uncertainty as to the true level of the NAV per share of a closed-ended fund, especially if the investments are unquoted
7. Asset range
-closed ended funds can invest in a wider range of assets
8. Tax
-they may be subject to different tax treatment

Question 46

Advantages of Collective Investment Schemes (CIS) compared to direct investment (9)

Answer 46

1. Access to expertise
2. Diversification
3. Some of the direct costs of investment are avoided
4. Holdings are divisible
5. Possible tax advantages
6. Marketability may be better than that of the underlying
7. Niche market access
8. Less haste
9. Can be used to track the return of a specific index

Question 47

Disadvantages of Collective Investment Schemes (CIS) compared to direct investment (3 and 1 specifically for individual investors)

Answer 47

1. Loss of control
2. Management charges incurred
3. Tax disadvantages
4. The funds stated investment objective might not be exactly appropriate for the specific INDIVIDUAL’s requirements (disadvantage for an individual investor)

Question 48

Reasons for investing overseas (3)

Answer 48

1. To match liabilities in foreign currency
2. To increase the expected returns
   … especially if the exchange rate falls against foreign currency
3. To reduce risk by increasing the level of diversification

Question 49

Drawbacks of investing overseas (16)

Answer 49

TRIPLE CARAMEL
T- possible TIME delays
- possible TAX disadvantages —> There might be withholding taxes imposed on overseas investments by the foreign tax authority that may not be able to be recovered
R- poorly REGULATED markets
-problems REPATRIATING funds
I- lack of good quality INFORMATION
P- POLITICAL risk
L- LANGUAGE problems
E- possibly high EXPENSE dealing costs

C- CURRENCY fluctuations
- need to appoint an overseas CUSTODIAN (They might be increased cost of investment as he will most likely have to appoint an overseas custodian to deal with the settlement, voting rights issues, holding share certificates)
A- additional ADMINISTRATION functions
R-RESTRICTIONS on ownership of certain shares by foreign investors
A- different ACCOUNTING practices
M- different market performance to the home market and therefore MISMATCH risk
E- cost of obtaining EXPERTISE
L- possible lack of liquidity

Question 50

Factors to consider before investment in emerging markets (10)

Answer 50

*1. Current market valuation
*2. Possibility of high economic growth rate
*3. Currency stability and strength
*4. Level of marketability
5. Degree of political stability
6. Market regulation
7. Restrictions on foreign investment
*8. Range of companies available
9. Communication problems
10. Availability and quality of information
*11. Economies and markets of smaller countries are less interdependent than those of the major economic powers, resulting in good diversification

Question 51

Advantages of market values vs calculated values (5)

Answer 51

1. Objective
2. Realistic as realisable value on sale (assuming the bid price is used)
3. Easy as it does not require calculation
4. Well understood and accepted
5. Can be used as a comparison to other valuation methods to see whether as asset seems over- or under-priced

Question 52

Disadvantages of market values vs calculated values (7)

Answer 52

1. May not be readily obtainable (e.g. unquoted instruments)
2. Volatile- values may fluctuate greatly even in the short term
3. May not reflect the value of future proceeds
4. A decision is required about whether bid, mid or offer prices should be used
5. Difficult to ensure consistency of basis with that of the liability valuation
6. Value reflects the position of the marginal investor rather than the individual investor (e.g. taxation)
7. May not be the realisable value on sale (eg in dealing in large volumes or illiquid stocks)

Question 53

Equity valuation methods (5)

Answer 53

1. Market value
2. Discounted dividend model [V=D/(i-g)]
3. Net asset value per share
4. Value added methods, such as Economic value added or shareholder value added
5. Measurable key factors of a company’s business

Question 54

4 ways to define risk

Answer 54

1. The probability of default
2. Expected variability of return
3. Risk of underperforming compared with competitors
4. Probability of failing to achieve the investors objectives

Question 55

The risk appetite of an institution will depend on: (3)

Answer 55

1. The nature of the institution
2. The constraints of its governing body and documentation (risk appetite of key stakeholders?)
3. Legal or statutory controls

Question 56

Factors influencing an institutions investment strategy (17)

Answer 56

I CANT EAT DRAPES

I- the Institutions risk appetite
- the Institutions objectives

C- the Currency of the existing liabilities
A- the Uncertainty of the existing liabilities (amount and timing)
N- the Nature of the existing liabilities (whether they are fixed in monetary terms l, real or varying in some way)
T- the Term of the existing liabilities

E- the Expected long-term returns from various asset classes
A- future Accrual of liabilities
T- Taxes and expenses ( Both the tax treatment of different investments and the tax position of the investor need to be considered)

D- the need for Diversification
R- statutory, legal or voluntary Restrictions on how the fund may invest
A- Accounting rules
P- the existing asset Portfolio
E- Environmental, social and governance (ESG) considerations
S- the Size of the assets, both in relation to the liabilities and in absolute terms
- Statutory valuation and Solvency requirements
- Strategy followed by other funds

Question 57

The factors influencing an individual’s investment strategy (5)

Answer 57

1. The characteristics of the assets and liabilities and matching cashflows
   - the currency, uncertainty, nature and term
2. The risk
   a. Variability of market values
   b. Diversification
3. Returns from different asset classes
   
   • consider tax advantages; “feel-good” factors and ESG
4. Investment constraints
   a. The level of excess assets
   b. The uncertainty of future income
   c. Risk appetite (age? dependents?)
5. Practical considerations
   
   • level of assets (min requirements to invest)
   • high expenses incurred
   • likely lack of investment expertise

Question 58

An aging population leads to: (4)

Answer 58

1. Less spending
2. A strain on social welfare systems
3. An increased cost of healthcare
4. The cost of education falling

Question 59

Advantages of public proprietary companies vs private proprietary companies (3)

Answer 59

1. Benefit from easier access to capital markets
2. Greater economies of scale
3. More dynamic management

Question 60

Actions to ensure good corporate governance (10)

Answer 60

1. Establishment of clear corporate AIMS and OBJECTIVES
2. Setting company TARGETS to meet the expectations of the key stakeholders
3. Production of regular internal management REPORTS
4. The regular publishing of AUDITED INTERNAL and PUBLISHED ACCOUNTS
5. The establishment of an AUDIT COMMITTEE
6. The establishment of clear OPERATING PROCEDURES
7. The appointment of NON-EXECUTIVE DIRECTORS to provide a more impartial view
8. The development and recording of JOB DESCRIPTIONS for management with key accountabilities and limits on authority
9. Establishment of EFFECTIVE MEASUREMENT PRACTICES
10. The implementation of REMUNERATION SCHEMES

Question 61

The principles of investment

Answer 61

1. A provider should select investments that are appropriate to the
   a. nature, term, currency, and uncertainty of the liabilities
   b. the provider’s appetite for risk
2. Subject to (1), the investments should also be selected so as to maximise the overall return on the assets, where overall return includes both income and capital.

Question 62

Regulatory controls affecting investment strategy (11)

Answer 62

1. Restriction on the types of assets that a provider can invest in
2. Restrictions on the amount of any particular type of asset that can be taken into account for the purpose of demonstrating solvency
3. A requirement to hold a certain proportion of total assets in a particular class
4. A requirement to hold a mismatch reserve
5. A limit on the extent to which mismatch is allowed at all
6. A requirement to match assets and liability by currency
7. Restrictions on the maximum exposure to a single counterparty
8. Custodianship of assets
9. Consideration if ESG criteria
10. Prescribed methods of valuation of assets
11. Require minimum levels of liquidity

Question 63

The limitations of immunisation theory (7)

Answer 63

Immunisation- the investment of the assets in such a way that the present value of the assets less the present value of the liabilities is immune to a general change in the rate of interest
1. Aimed at meeting FIXED MONETARY LIABILITIES, many investors need to match real liabilities
2. By immunising, the possibility of mismatching profits/losses is removed apart from a second-order effect —> rules out investment in assets with high expected returns that are uncertain [Removes or reduces the chances of losses but also removes the chances of outperformance]
3. Relies on SMALL CHANGES in interest rates. The fund may not be protected against large changes
4. ASSUMES A FLAT YIELD CURVE and requires the same change in interest rates at all terms. In practice, the yield curve changes shape from time to time
5. IGNORES DEALING COSTS of rearranging assets [Requires regular rebalance to maintain immunised position- might be costly to maintain]
6. Assets of a suitably long discounted mean term MAY NOT EXIST
7. TIMING of asset proceeds and liability outgo may not be known

Question 64

Before making a tactical switch, you should consider: (6)

Answer 64

1. The extra EXPECTED RETURN compared with additional RISK
2. Any CONSTRAINTS on changing the portfolio
3. The EXPENSES of making the switch
4. Any problems of switching a LARGE AMOUNT of assets
5. TAX LIABILITY arising if capital gain is crystalised of
6. The difficulty of carrying out the switch in GOOD TIME

Question 65

Number of model points depends on: (6)

Answer 65

1. Number of model points that can be handled by the model
2. Computing power available
3. Time constraints
4. The heterogeneity of the class
5. Sensitivity of the results to different choices of model points
6. Purpose of the exercise

Question 66

Steps of developing a deterministic model (8)

Answer 66

1. Specify the purpose and key features of the model
2. Obtain and adjust the data
3. Set the parameters (using past data and estimation techniques), assumptions and any dynamic links
4. Construct a model based on the expected cashflows
5. Check the accuracy and fit of the model, and amend if necessary
6. Run model using estimates of the values of variables in the future
7. Run model several times to assess the sensitivity of the results to different parameter values
8. May: run model under different scenarios, changing many different parameters

Question 67

Advantages of a deterministic model (5)

Answer 67

1. More readily explicable to a non-technical audience…
   … since it does not involve the explanation of probability distributions
2. Clearer what economic scenarios have been tested
3. Relatively cheaper
4. Speed of design and quicker to run
5. Complex models cause users to think it’s accurate without verification

Question 68

Steps of developing a stochastic model (8)

Answer 68

1. Choose a stochastic asset model ( purpose and key features of the model)
2. Obtain and adjust the data
3. Determine assumptions
   — stochastic —> choose a suitable density function for each variable
   — deterministic —>demographic, surrender rates, expense assumptions
4. Specify correlations between assumptions and variables
5. Construct a model
   — determine model points
   — what will the model be doing?
6. Check the accuracy and fit of the model, and amend if necessary
7. Run model many times, each time using a random sample from the chosen density function(s)
8. Produce a summary of the results that shows the distribution of the modelled results after many simulations have been run

Question 69

Advantages of a stochastic model (7)

Answer 69

1. Tests a wider range of economic scenarios
2. Tests for many scenarios that you might not even have thought of under a deterministic model
3. It allows better for the random nature of variables (variability of model parameters)
4. …. And the correlation between them
5. Higher quality of results
6. More useful for assessing the impact of financial guarantees and options or to allow for investment mismatching risks
7. The output of a stochastic model forms a distribution of values from which statistics such as the mean and the variance of the output can be calculated

Question 70

Demographic factors that increase the cost of state retirement provision (3)

Answer 70

1. Falling birth rates —> increased number of pensioners relative to the number of people in the working population
2. Increased life expectancy
   (1 and 2 contribute to an increasing population)
3. Changes in employment patterns
   — early retirement
   — joining the working population late due to pursuing higher education

Question 71

How would the state deal with increasing costs of state retirement provision? (8)

Answer 71

1. Acceptance —> increase tax for contributions
2. Increasing minimum retirement age
3. Reducing the number of people eligible for the benefit
   — only pay the benefit to those who have contributed for a certain number of years (this would also require people to contribute for longer; more likely to retire later; receive benefit for a shorter period)
   — only pay the benefit to those who are still residents of the country
4. Reduce/freeze the starting level of the benefit
5. Change the benefit to be means-tested
6. Increase the stringency of any means-testing carried out
7. Reducing the level of pension increases
8. Encourage or compel additional private provision through tax incentives/regulation

Question 72

Disadvantages of a stochastic model (5)

Answer 72

1. More complex and time consuming —> more expensive to run
2. Degree of spurious accuracy
3. More difficult to communicate and interpret results
4. Complexity of design and tests may lead to operational risk
5. Model output is heavily dependent on choice of probability distributions for its parameters for the stochastically modelled variables

Question 73

Key risks relating to data: (6)

Answer 73

1. Data is INCOMPLETE or INACCURATE
2. Data is not credible due to being of INSUFFICIENT VOLUME
3. The data are NOT SUFFICIENTLY RELEVANT to the intended purpose
4. Past data will not reflect what will happen in the future
5. Chosen data groups may not be optimal
6. The data are NOT AVAILABLE IN AN APPROPRIATE FORM for the intended purpose

Question 74

Guidelines in a data governance policy (6)

Answer 74

Data governance is the overall management of the availability, usability, integrity and security of data
Data governance policy is a documented set of guidelines for ensuring the proper management of an organisations data

1. ROLES and RESPONSIBILITIES of individuals in the organisation with regard to data
2. How an organisation will CAPTURE , ANALYSE and PROCESS information
3. Issues wrt data SECURITY and PRIVACY
4. CONTROLS that will be put in place to ensure that the required data standards are applied
5. How the adequacy of the controls will be MONITORED on an ongoing basis wrt data usability, accessibility, integrity and security
6. Will provide a mechanism for ensuring that the RELEVANT LEGAL AND REGULATORY REQUIREMENTS in relation to data management are met by the insurer

Question 75

Problems with industry wide data collection schemes: (5)

Answer 75

1. Data supplied by different companies may NOT be COMPARABLE because:
   a. Companies operate in DIFFERENT GEOGRAPHICAL or SOCIO-ECONOMIC SECTIONS
   b. The POLICIES SOLD by different companies are not identical
   c. SALES METHODS are not identical
   d. The companies will have DIFFERENT PRACTICES
   e. The NATURE OF THE DATA stored by different companies will not be the same
   f. The CODING used for the risk factors may vary from organisation to organisation
2. Data may be LESS DETAILED/flexible
3. The data may be more OUT-OF-DATE
4. The data QUALITY may be poor
5. NOT ALL ORGANISATIONS CONTRIBUTE and those that do may not be representative of the market as a whole

Question 76

Data checks (12)

Answer 76

1. Reconciliation of member/policy numbers (using previous data and movement data)
2. Reconciliation of benefits and premiums (Against accounting data or previous data and movement data)
3. Reconciliation of beneficial owner and custodian records where assets are owned by a third party
4. Consistency of contribution and benefit levels with the accounts
5. Consistency between average sum assured and premium for each class, and when compared to its previous investigations
6. Consistency of asset income data and accounts
7. Consistency between start and end period shareholdings
8. Movement data against accounts
9. Validity of dates
10. Full deed audit for certain assets
11. Records picked at random for spot checks
12. Check for unreasonable or unusual values for example impossible dates of birth or death

Question 77

Key factors affecting the choice of assumptions in a model (5)

Answer 77

1. The use to which the model will be put
2. Financial significance of the assumptions
3. Consistency of assumptions
4. Legislative and regulatory requirements
5. The needs of the client

Question 78

Demographic assumptions (7)

Answer 78

1. Birth rates
2. Death rates
3. Mortality rates
4. Morbidity rates
5. New entrant rates
6. Proportion married
7. Rates of withdrawal

Question 79

Economic assumptions (6)

Answer 79

1. Investment returns
2. Discount rate
3. Earnings inflation
4. Price inflation
5. Pension increase
6. Expenses

Question 80

Main sources of data (5)

Answer 80

1. Internal data
2. National statistics
3. Industry data
4. Actuarial tables
5. Reinsurers data

Question 81

When using past data, the actuary needs to consider how to deal with and make adjustments for: (7)

Answer 81

1. Abnormal fluctuations (and one-off impacts)
2. Changes in the experience with time
3. Random fluctuations
4. Changes in the way in which the data has been recorded
5. Potential errors in the data
6. Changes in the mix of homogenous groups within the past data
7. Changes in the mix of homogenous groups to which the assumptions apply

Question 82

Features that make a contract riskier (6)

Answer 82

1. Lack of historical data
2. High guarantees
3. Policyholder options
4. Overhead costs
5. Complexity of design
6. Untested market

Question 83

Types of Liability insurance (5)

Answer 83

1. Employers’ liability insurance
2. Motor third party liability insurance (also fleet motor third party liability)
3. Public liability insurance
4. Product liability insurance
5. Professional indemnity insurance

Question 84

Types of property damage insurance (6)

Answer 84

1. Residential building
2. Movable property insurance
3. Commercial building
4. Land vehicles/Motor property (also fleet motor property)
5. Marine craft
   a. Marine hull cover
   b. Marine cargo
   c. Marine freight
6. Aircraft

Question 85

Types of financial loss insurance (3)

Answer 85

1. Business interruption cover
2. Fidelity guarantee
3. Pecuniary loss cover

Question 86

Types of fixed benefit insurance (3)

Answer 86

1. Personal accident cover
2. Unemployment Insurance
3. Health

Question 87

Advantages of grouping shares by industry (5):

Answer 87

1. INVESTMENT ANALYSTS CAN SPECIALISE in particular industries
2. By analysing one industry, we have PREPARED THE BASIS for analysing the many companies within the industry
3. STATISTICS are often presented for whole industries, and trade journals are clearly ‘by industry’
4. ACCOUNTS are often presented in a similar format and use the same jargon
5. By looking at the industry, we effectively REDUCE THE NUMBER OF FACTORS TO CONSIDER for each individual company analysis

Question 88

Disadvantages of grouping shares by industry (4):

Answer 88

1. Investment analysts may become TOO WRAPPED UP IN THEIR OWN INDUSTRY and become less proficient at choosing between industries
2. Not all companies operate in a single industry
3. Sometimes companies may not conform to their ‘INDUSTRY NORM’
4. Although industry shares are correlated, OVERALL MARKET MOVEMENT EXPLAINS MOST OF THE SHARE PRICE MOVEMENTS

Question 89

Factors in assessing a property investment (10)

Answer 89

1. Location
2. Quality of tenant
3. Age, standard of repair and modernisation
4. Conditions of lease
5. Price, rent and yield
6. Type of property
7. Ownership of property (freehold vs leasehold)
8. Adaptability
9. Facilities provided
10. Development potential

Question 90

Practical difficulties of running property based unit trusts (3)

Answer 90

1. Establishing property prices, and hence unit prices
2. Buying and selling property quickly to meet new and cancelled units
3. The large minimum size of property investment

Question 91

Factors that cause a difference in yield between a fixed interest bond and an index-linked bond (5)

Answer 91

1. Inflation protection by the index-linked bond
2. Relative marketability
3. Different levels of coupons due to
   - tax
   -duration
4. Risk of default
5. Supply and demand issues arising due to the relative strengths of the two currencies

Question 92

Principal factors contributing to variations in mortality and morbidity (11)

Answer 92

1. Occupation
2. Housing
3. Nutrition
4. Climate/geography
5. Political unrest
6. Education
7. Genetics
8. HIV
9. Dangerous activities
10. Travel
11. Marital status

Question 93

Practical investment constraints for individual investors (5)

Answer 93

1. Less access to research facilities
2. Less good quality, up-to-date investment information
3. Inappropriate levels of expertise for direct investment
4. Less time available
5. Investors will not generally have the cash resources to:
   a. Invest directly and remain well-diversified
   b. Invest directly in assets with large unit size (e.g. commercial property; minimum requirements on some assets)
   c. Take advantage of attractive investment opportunities that become available from time to time at short notice
   d. Achieve economies of scale (individuals will have higher relative expenses than institutions)

Question 94

Factors affecting the degree to which a pension scheme can mismatch (15)

Answer 94

SCHEME
1. The FUNDING LEVEL of the scheme- the higher the funding level, the greater the scope to mismatch
2. the SIZE of the scheme - all else being equal, a larger scheme can take more mismatching risk
3. the DEALING COSTS involved
4. the scheme’s investment EXPERTISE
5. whether the scheme is EXPANDING or CONTRACTING
6. the approach taken by COMPETITORS schemes
7. the need for DIVERSIFICATION
8. the extent to which benefits are insured, for example, if the scheme has insured death-in-service benefits, then there is greater scope to mismatch

SPONSOR AND TRUSTEES
9. the OBJECTIVES of the sponsor and the trustees
10. the RISK APPETITE of the sponsor and the trustees

ASSETS
11. LEGISLATION affecting which asset classes can be held
12. SCHEME RULES affecting which asset classes can be held
13. TAX treatment of different assets
14. the AVAILABILITY of ASSETS, for example, whether index-linked bonds are available
15. the RELATIVE CHEAPNESS and DEARNESS of different asset classes

Think of factors affecting investment strategy and benefit schemes

Question 95

Limitations of a deterministic asset-liability model when testing the suitability of a given asset distribution (4)

Answer 95

1. The investment return assumptions in a deterministic model are based on estimates of the expected return from each asset class. This FAILS TO TAKE INTO ACCOUNT THE VARIABILITY OF ASSET RETURNS…
   …and the correlations between investment returns on different asset classes…
   … and between the assets and liabilities.
2. Run a deterministic model a number of times considering different scenarios (e.g. low inflation, high inflation, etc.).
   .. and in practice only a limited number of runs will be feasible (TIME CONSTRAINTS)
3. Scenario setting is, however, highly subjective …
4. If there is a lot of variability in the parameters, even scenario testing may not identity the true extent of the risk of insolvency.
   With a deterministic model, a problem will only be identified if the relevant scenario is actually modelled.

Question 96

Circumstances under which a passive investment strategy is appropriate (9)

Answer 96

1. the INVESTMENT MARKET IS VERY EFFICIENT , so that there are unlikely to be any price inefficiencies to be exploited
2. … especially if the company has a large portfolio
3. the portfolio consists of UNMARKETABLE ASSETS, so that the high dealing expenses associated with active trading would eliminate any additional investment returns
4. the investor has LITTLE INFORMATION or EXPERTISE in a particular investment market, so may wish to simply track or match a particular benchmark or index, to reduce the possibility of underperformance
5. the investor’s STATED INVESTMENT OBJECTIVE is to pursue a particular form ot passive strategy - e.g. track an index.
6. It may be difficult to take positions timeously and without moving prices themselves
7. May want to REDUCE COSTS believing that the benefits of active management do not outweigh the costs
8. Active managers may have underperformed
9. Done a RISK BUDGETING exercise and have decided to allocate to strategic risk

Question 97

Advantages of risk budgeting (2)

Answer 97

1. Risk budgeting bases asset allocations not purely on the asset’s expected return but also on its risk contribution to the portfolio.
2. Risk budgeting increases the attention paid to low correlation investments.
   Allocations to such investments can reduce the total risk of the portfolio through diversification.

Question 98

2 parts of the risk budgeting process

Answer 98

1. deciding how to allocate the maximum permitted overall risk between active risk and strategic risk
2. allocating the total fund active risk budget across the component portfolios.

• When setting the strategic asset allocation, the RISK TOLERANCE of the stakeholders in the fund is important
• The CONSTRAINT is that the total risk of the portfolio must stay at or below a targeted level.
• Increased attention is paid to low correlation investments so that the allocation to such investments can reduce the total risk of the portfolio through diversification
• The DISTRIBUTION of RISK will depend on:
— The risk attitude of the sponsors, they must consider how much systematic risk they are willing to take to achieve higher returns.
— It will also depend on whether the sponsors believe that active management adds value or not
• Risk exposures will need to be monitored over time and rebalancing should be carried to keep the total risk within tolerable limits

Question 99

It is necessary to review the continued appropriateness of any investment strategy at regular intervals because: (3)

Answer 99

1. The liablity structure may have changed significantly due to
   - writing of a new class of business
   - a takeover
   -benefit improvement
   -legislation
2. The funding or free asset position may have changed significantly
3. The manager’s performance may be significantly out of line with that of other funds.

Question 100

Advantages of adapting an existing model compared to buying a new model (4)

Answer 100

1. Not incur the cost of buying a new model, but will need to bear the COSTS of adapting the existing one
2. Existing staff will have an UNDERSTANDING of the workings and limitations of the existing models (existing models should be well-documented).
3. By adapting a model ‘in-house’, existing staff can ensure CONSISTENCY OF DESIGN with existing models.
4. Existing staff will DEVELOP EXPERTISE in modelling, reducing future reliance on external providers for modifications

Question 101

Advantages of purchasing a new model compared to adjusting an existing model (2)

Answer 101

1. The model should be well designed and validated, in order to be a successful commercial product.
2. The model may be more FLEXIBLE than existing models and therefore may be more useful in future for other purposes (e.g. valuation, ALM, projections).

Question 102

How to minimise model error (2)

Answer 102

1. Consider lots of potential models
2. Employ suitable expertise to identify the most appropriate model

Goodness of fit test???

Question 103

How to minimise data error (2)

Answer 103

1. Ensure data is regularly updated
2. Perform data checks.

Question 104

How to minimise parameter error (2)

Answer 104

1. Carry out lots of sensitivity testing to identify the key assumptions.
2. Pay careful attention to the setting of those financial assumptions which are most important

Question 105

8 conditions that must be applied when processing personal data, according to POPIA

Answer 105

1. ACCOUNTABILITY - The party responsible for processing the data is also responsible for compliance with POPIA
2. PROCESSING LIMITATION - Information must be processed in a fair, lawful and relevant manner, after consent is given by the data subject.
3. PURPOSE SPECIFICATION- Personal information must be collected for a specific purpose. Record keeping to be destroyed when personal data is no longer relevant or authorised to be held.
4. FURTHER PROCESSING LIMITATION - Further processing must be compatible with the initial collection purpose.
5. INFORMATION QUALITY - Data completeness, accuracy and updates to be ensured by holder of the data.
6. OPENNESS - Documentation to be maintained on all processing operations and maintaining transparency on data use.
7. SECURITY SAFEGUARDS - Integrity and confidentiality of personal data must be secured and all processing done only by authorised operator. Notification to be done on security compromises.
8. DATA SUBJECT PARTICIPATION- The data subject may request confirmation of personal data held and request correction or deletion of any inaccurate, misleading or outdated information held.

Question 106

Key requirements of a model (10)

Answer 106

1. Model should be adequately DOCUMENTED
2. Workings of the model should be easy to appreciate and communicate
3. The RESULTS should be DISPLAYED CLEARLY and should be communicable to those whom the results will be presented
4. Should exhibit sensible joint behaviour of model variables
5. Assumptions should be consistent
6. Capable of independent verification
7. Not overly complex
8. Capable of development and refinement
9. Capable of being implemented in a range of ways
10. Have an appropriate time period between projected cashflows, balancing the reliability of output with the speed of running the model

Question 107

Limitations of a model (4)

Answer 107

1. Results are only as good as the underlying model
2. Dependent on data
3. Dependent on assumptions
4. Level and timing of cashflows is uncertain

Question 108

Risks relating to data governance failure (5)

Answer 108

1. Legal and regulatory non-compliance
2. Inability to rely on data for decision making
3. Reputational risk
4. Reputational risk can lead to loss of business:
   a. Existing customers moving to competitors
   b. Compromised ability to attract new business
5. Incurring additional costs

Question 109

Factors that determine the degree of accuracy needed when determining assumptions (2)

Answer 109

1. Financial significance of the assumption concerned
2. Purpose for which the assumptions are required
   (We can then determine a basis)

Question 110

Advantage of net present value as a profit criterion (1)

Answer 110

Given a choice between two different sets of cashflows (e.g. relating to two different products), economic theory dictates that the investor should choose that with the higher net present value.

However this assumes:
1. a perfectly free and efficient capital market
2. that the NPV is calculated using a discount rate, which correctly reflects the inherent riskiness of the product.

Question 111

Disadvantages of net present value as a profit criterion (2)

Answer 111

1. It is not a very simple measure to present to non-technical people.
2. By itself it tells us very little - it would need to be expressed in terms of a ratio for it to be more meaningful.
   For example, NPV as a percentage of:
   • expected present value of premiums
   • distribution costs / initial commission.

Question 112

Advantages of the Internal Rate of Return as a profit criterion (3)

Answer 112

1. It is a simple measure.
2. It is compatible with shareholders saying that they want a return of at least ×%.
3. It is easily comparable with other forms of investment (e.g. other products, projects).

Question 113

Disadvantages of the Internal Rate of Return as a profit criterion (3)

Answer 113

1. It might not be unique.
2. It might not exist.
3. It is difficult to relate to other measures (e.g. premium income).

Question 114

Advantages of the discounted payback period as a profit criterion (2)

Answer 114

1. A useful means of comparing products if capital is a particular problem.
2. It is easy to explain as a ‘break-even’ point.

Question 115

Disadvantage of the discounted payback period as a profit criterion (1)

Answer 115

It will often not agree with the net present value as a means of deciding between two different sets of cashflows because the discounted payback period IGNORES CASHFLOWS SUBSEQUENT TO THE DPP itself.

Question 116

Assumptions needed for estimating the value of a defined contribution scheme (10)

Answer 116

Assumptions about the DEVELOPMENT OF THE FUND:
1. The investment return on assets held
2. Any future changes in the split of assets held across investment funds
3. The amounts of future contributions
4. Salary growth (if contributions are expressed as a % of salary)
5. The expenses of the contract.
6. The mortality rate pre-retirement
7. No early withdrawal

Assumptions about the PENSION THAT WILL BE RECEIVED :
8. The proportion of fund that will be taken as cash at retirement
9. The annuity rate that will apply at retirement.
The annuity rate will depend on the following assumptions:
• interest rates / bond yields at the expected retirement date
• post-retirement mortality rates
• inflation, if it is an escalating pension
• the form in which the pension will be taken (e.g. frequency, spouse’s pension, guaranteed minimum period) if not known.

10. No legislative changes affecting the pension payable.

Question 117

Factors to take into account when reviewing premium rates (7)

Answer 117

1. Adjust the existing assumptions in light of EXPERIENCE
2. Review the relevance and suitability of the possible EXTERNAL SOURCES (esp if the company has little internal/experience DATA)
3. Adjustments may need to be made to reflect the LEVEL of UNDERWRITING used
4. Consider whether the TARGET MARKET actually achieved is the same as that anticipated in the pricing basis
5. Consider any revised rates from REINSURERS
6. Impact of COMPETITION
7. Any MARGINS for risk or prudence

Question 118

Factors that affect the STATED rate of mortality for different occupations (9)

Answer 118

1. Difficulty of recording the independent effect of the occupation
2. Actual effects:
   - environment
   - risk of accidental death
   - stress level
3. Possible non-correspondence in the calculation
4. Vagueness in census returns may result in the wrong occupation being recorded
5. A widow or widower may elevate the occupation of their spouse
6. Lives’ previous occupation is recorded
7. An occupation may be selected against
8. Lack of statistics (volume)
9. Standardised mortality rates should be used

Question 119

Why is it necessary to subdivide the function of the expenses for the purpose of premium rating (4)

Answer 119

1. They will need to be allowed for in different ways when DETERMINING EXPENSE LOADINGS for use in premium rating. E.g., expressed as a percentage of premiums; be a fixed amount per policy, be proportional to the amount of benefit or sum assured, or fixed per policy.
2. Helps with ANALYSIS of EXPENSES by targeting sources of profits or inefficiencies.
3. Knowing whether the function of a particular expense relates to securing new business, maintaining existing business or terminating business GIVES INFORMATION AS TO THE TIMING OF THE OCCURRENCE of the expense which helps the provider in deciding whether the expense should be loaded for as an initial, renewal or termination expense.
4. Ensure that costs which are only incurred by regular premium business (e.g. premium collection expenses) are not included in expense loadings for single premium and paid-up policies.

Question 120

Purpose for expense allocation (7)

Answer 120

1. Pricing (expense loadings to calculate premiums)
2. Provisioning (expense loadings to calculate provisions)
3. Understanding the profitability of a particular product
   —understanding the cross-subsidy between products (a point from Sasha)
4. Analysing sources of surplus
5. Analysing areas of inefficiency
6. Expense budgeting
7. Cashflow management- to ensure that liquid funds are available to pay the expenses

Question 121

Expenses can be allocated by: (2)

Answer 121

1. Class of business (direct and indirect)
2. Allocation to function (commission, initial, ongoing, investment and termination)

Question 122

Expense loadings may need to be adjusted in relation to: (3)

Answer 122

1. Cross subsidy
2. Inflation (historic and prospective)
3. Competition

Question 123

How would the results of an expense analysis be included in premium rates? (5 steps)

Answer 123

1. ALLOCATE EXPENSES in the same way as the premium rates will be split, so at least by product and possibly by type of cover.
2. Expenses will be SEPARATE in line with the categories:
   - between fixed and variable
   - between direct and indirect
   - by product / class of business
   - by function (type or timing of expense: initial, renewal, termination)
   - further sub-division (e.g. initial between sales / marketing and administration)
   - by what the expense is most closely linked to (or type of expense loading).
3. Expenses RELATED to the NUMBER of POLICIES or CLAIMS: would need to be divided by an average policy or claim size before being loaded into the premium rates.
4. FIXED expenses: would have to be divided among an assumed volume of business before being allocated.
5. INDIRECT expenses: would be apportioned across classes.

Question 124

Why is it important to reflect the results of an expense analysis in the premiums charged (3)

Answer 124

1. To CHARGE premiums that will cover the expected level of initial and ongoing expenses associated with writing and subsequently servicing the contracts
2. To understand the levels of CROSS-SUBSIDY in the premiums, for example, between large and small contracts
3. To UNDERSTAND the actual costs of writing and servicing contracts and how these may vary, for example, by: distribution channel; regular and single premium contracts; without-profit, with-profit and unit-linked contracts.

Question 125

Contract design factors (18)

Answer 125

AMPLE DIRECT FACTORS
Administration systems
Marketability
Profitability
Level and form of benefits
Early leaver benefits

Discretionary benefits
Interests and needs of customers
Risk appetite of the parties involved
Expenses vs charges
Competition
Terms and conditions of contract

Financing (capital requirements)
Accounting implications
Consistency with other products
Timing of contributions or premiums
Options and guarantees
Regulatory requirements
Subsidies (cross-)

Question 126

Features of contract design that increase financing requirements (8)

Answer 126

1. Lack of historical data
2. High guarantees
3. Policyholder options
4. High initial expenses
5. High initial commission
6. Overhead costs
7. Without profit designs with non-reviewable premiums
8. Regular premium designs

Question 127

Reasons why a surplus would arise in a DB scheme (3)

Answer 127

1. Assumptions about future experience were unduly pessimistic
2. Experience turned out to be favourable
3. Sponsor payed more than the recommended contributions

I’m sure there’s more reasons

Question 128

Reasons why a surplus would arise in a DC scheme (1)

Answer 128

1. An admin issue

Question 129

Key features of enterprise risk management (3)

Answer 129

1. CONSISTENCY across business units
2. HOLISTIC- considers the risk of an enterprise as a whole, rather than in isolation, thus allowing appropriately for diversification
3. Seeking OPPORTUNITIES to enhance value

Question 130

Customers logical needs (4)

Answer 130

1. Maintaining current lifestyle
2. Protection
3. Accumulation for a known purpose
4. Accumulation for a unknown purpose

Question 131

Customer need of a pension contract (2)

Answer 131

1. Providing income in retirement for individuals and possibly dependents
2. Lump sum payments to dependents if an individual dies before retirement

Question 132

Customer needs for endowment assurances (3)

Answer 132

1. A means of transferring wealth
2. A means of repaying capital on a loan
3. A vehicle for saving money for retirement

Question 133

Customer needs for a Whole Life Assurance (3)

Answer 133

1. Provide long-term protection to dependents (transferring wealth in a tax efficient way)
2. Providing for funeral expenses
3. Meeting any liability to tax (inheritance tax or death duties or estate duties)

Question 134

Customer needs for a Term Assurance (2)

Answer 134

1. Protection against financial loss for the assureds dependants
2. For a decreasing term assurance:
   a. Repay the balance outstanding under a loan
   b. Provide income for a family with children following the death of the income provider until such time as the latter can fend for themselves

Question 135

Use to meet customer needs of a covertable or renewable term assurance

Answer 135

Combine the attractions of a TA, in terms of cheap death cover; with the certainty of being able to convert to a permanent form of contract when it can be afforded without health evidence being provided

Question 136

Customer needs of an immediate annuity (1)

Answer 136

1. Meet a financial need for an income for the remainder of the life of the assured, after his retirement

Question 137

Customer needs of an deferred annuity (2)

Answer 137

1. Enabled individuals to build up a pension that becomes payable on retirement from gainful employment
2. Meet any need for a cash lump sum at the vesting date of the annuity

Question 138

Customer need of an income drawndown (1)

Answer 138

Should the member die before having to secure an annuity, the members heirs can inherit the balance of the fund

Question 139

Advantages of an income drawndown (3)

Answer 139

1. Able to earn a RETURN on their invested fund
2. FLEXIBILITY within the legislative requirements in terms of how much to take each year as an income
3. ANNUITY RATES may be poor but improve in the future

Question 140

Risks of an income drawndown (5)

Answer 140

1. If only the interest is taken each year, the members income could be volatile
2. If too high a level of income is taken, the capital could potentially reduce to zero
3. Admin charges may be high
4. Remaining fine on the members death may be insufficient for dependents
5. Tax charge in the residual fund on the members death

Question 141

Customer needs of investment bonds (3)

Answer 141

1. Earn a higher return on funds that are not currently required to meet their needs
2. Ensure a minimum payout on death
3. Can withdraw money

Question 142

Customer need of key person cover (3)

Answer 142

1. Buy out the individual from the partnership
2. Cover any loss of profits as a result of the loss of the key person
3. Meet the costs of finding a replacement

Question 143

Customer needs of critical illness cover (11)

Answer 143

1. INCOME can be provided when the individual cannot work as a result of a CI
2. The benefit can be used to repay a mortgage or other LOAN
3. MEDICAL COSTS can be funded when the CI requires surgery or treatment
4. Business partners can purchase CI policies in the lives of each other such that the benefits will fund the buyout of the stake in the partnership - KEYMAN cover
5. It can fund a CHANGE of LIFESTYLE in order to improve the claimant’s health
6. Other needs suggested include RECUPERATION AFTER ILLNESS, taxation planning medical aids (eg the installation of specialist equipment in the home.
7. Home adaptation
8. Expensive equipment
9. Rehabilitation
10. Recuperative holiday
11. Childcare

Question 144

Customer needs of long-term care (2)

Answer 144

1. Financing the cost of care in old age/financial protection when a person becomes unable to look after themselves
2. Addresses concerns if the care available from the state is inadequate
   - domestic support
   -live-in care
   -residential care
   -medical care

Question 145

Customer needs of private medical insurance (2)

Answer 145

1. If no state funded care exists then PMI will provide for all forms of healthcare needs on an indemnity basis
2. If the states provide some level of healthcare then PMI is bought when an individual requires a higher level of care such as:
   • medical attention without waiting;
   • highest standard of accommodation;
   • doctor of choice;
   • medical attention in a local or private hospital

Question 146

Role of the Central Risk Function (7)

Answer 146

1. Giving ADVICE TO THE BOARD on risk
2. ASSESSING the overall risk being run by the business.
3. Making comparisons of the of the risks being run by the business with its risk appetite
4. Acting as a CENTRAL FOCUS POINT for staff to report new and enhanced risks.
5. Giving GUIDANCE to LINE MANAGERS about the identification and management of risks
6. MONITORING progress on risk management
7. Pulling the WHOLE PICTURE together

Question 147

Responsibilities of the Chief Risk Officer (CRO) (10)

Answer 147

• Companies that are diverse geographically and in terms of product lines
• Taking on a risk may magnify or diversify a risks
• Risk management will be undertaken at the business unit level…
•… where a risk manager could be assigned it to each business unit and geographical location
• it will be essential for risk to be managed from an enterprise perspective and a single risk officer it with the individual risk managers report
[Very Little People Can Comprehend Royalty Being Super Mean Everyday]
V- 1. Managing Various risk functions
L- 2. Providing Leadership and direction
P- 3. Ongoing RISK POLICY DEVELOPMENT
C- 4. Allocation at CAPITAL across the firm
C- 5. COMMUNICATING with stakeholders about the organisations risk profile
—credit rating agencies
— regulators
R- 6. RISK REPORTING
B- 7. ALLOCATING the RISK BUDGET to business units after allowing for diversification
S- 8. Developing Systems to analyse , monitor and manage risks.
M- 9. MONITORING the group exposure to risk and documenting the risks that have materialised
E- 10. Designing and implementing an ERM framework across the company

Question 148

3 lines of defence of a risk management model

Answer 148

1. Line management staff in the business units
2. The chief risk officer (CRO), risk management team and the compliance team
3. The board and audit function

Question 149

Operational risk can arise from: (5)

Answer 149

1. Inadequate internal processes, people or systems
2. CONDUCT RISK- Poor conduct towards customers / the market
3. DOMINANCE RISK- dominance of a single individual
4. Reliance on third parties
5. the failure of plans to recover from an external event.

Question 150

Climate change may generate the following types of risk: (3)

Answer 150

1. Physical- arising from the first-order effects of environmental changes, as. extred hone weather
2. Transition - arising from economic, political and market changes
3. Liability -relating to compensation claims due to the impacts of climate change.

Question 151

Risks that need to be managed for benefits that are known in advance (6)

Answer 151

1. Inadequate funds having been set aside, i.e. underfunding
2. Insolvency of sponsor / provider
3. Asset / liability mismatching
4. Illiquid assets, i.e. funds not available when required
5. Change in the benefit promise, e.g. by the state or provider
6. Beneficiaries’ needs not being met, e.g. due to :
   • misunderstanding,
   • inflation erosion of value,
   • changed circumstances.

Question 152

The risk of inadequate benefits, when the benefits are not known in advance arises from: (4)

Answer 152

1. Investment returns being lower than expected
2. Expense charges being higher than expected
3. Where relevant, annuity purchase terms being poorer than expected (e.g. defined contribution scheme, if an annuity is taken).
4. Beneficiaries’ needs not being met, either due to
   • design
   • inflation erosion of value.

Question 153

For contributions / premiums that are known in advance, the risks are: (4)

Answer 153

1. The contributions / premiums are unaffordable and hence not made
2. Insufficient liquidity to make the payments in a timely manner
3. The contributions / premiums are linked to an inflationary factor, thereby introducing the risk that they increase more rapidly than anticipated
4. The contributions / premiums are not linked to inflation and therefore the resultant benefits are eroded by inflation.

Question 154

Investment risks (7)

Answer 154

1. Uncertainty over the level and incidence of investment income and capital gains
2. REINVESTMENT risk rising from mismatching assets and liabilities
3. DEFAULT RISK
4. Investment returns being LOWER THAN EXPECTED
5. LIQUIDITY RISK
6. Lack of DIVERSIFICATION
7. Changes in the TAXATION of investment income and gains and investment expenses

Question 155

Disadvantages of the formula approach to calculate the premium to charge for benefits (2)

Answer 155

1. Only really suitable for modelling fairly simple contracts and for fairly simple situations.
   For example, it does not allow for:
   -setting up any prudent supervisory provisions
   -the cost of capital supporting the product
   -the time value of any options and guarantees
   -experience rating.
   It would also only be able to cope with very simple taxation and expenses.
2. The formula method is less well suited to SENSITIVITY TESTING and to the use of an explicit PROFIT CRITERION.

Question 156

Distribution system will affect (4)

Answer 156

1. The withdrawal rate of customers
2. The target market (financially sophisticated or not)
3. Contract design: e.g., Underwriting requirements. Direct marketing usually has low underwriting
4. The need for competitive terms.
   - independent intermediaries have the highest need for competitive terms

Question 157

Reasons why am general insurer would undertake an investigation of premium rates (15)

Answer 157

PROFITABILITY
1. assess the profitability of the CURRENT PREMIUM RATES, either overall or for particular subsets of the business written
2. as above, but for the PROPOSED NEW PREMIUM RATES
3. assess the extent of any CROSS-SUBSIDIES between rating factors or other policy groups
4. examine why actual LOSS RATIOS differ from expected for certain segments

INTERNAL FACTORS
5. assess the impact on premium rates if they were updated to reflect RECENT EXPERIENCE
6. assess the impact of potential COVER CHANGES
7. assess the impact of an UPDATED COST OF CAPITAL
8. assess the possibility of writing business as a LOSS LEADER
9. assess the possibility of using MARGINAL COSTING

EXTERNAL ENVIRONMENT
10. Compare with premium rates offered by COMPETITORS
11. consider the current position of the UNDERWRITING CYCLE
12. assess the impact of changes in LEGISLATION , REGULATION or TAXATION
13. assess the potential impact of NEW TECHNOLOGY
14. assess possible changes in DISTRIBUTION approach
15. assess the impact of REINSURANCE changes or opportunities.

Question 158

Factors that would affect the price charged for the transfer of liabilities on a merger or acquisition (5)

Answer 158

1. Theoretical value of the liabilities
2. Costs incurred in performing the transaction (e.g. legal expenses)
3. Size of the transaction relative to the overall deal
4. Relative bargaining power of the parties involved
5. Competitive position of the transaction

Question 159

Reasons for a fall in new business (10)

Answer 159

COMPETITORS’ ACTIONS
1. the introduction of NEW PRODUCT FEATURES by competitors
2. reduction in competitor PREMIUM RATES
3. COMMISSION rises by competitors

OTHER EXTERNAL FACTORS
4. DOWNTURN in the ECONOMIC situation, making premiums less affordable
5. changes to the TAX environment
6. changes to the REGULATORY environment
7. introduction of or improvement in STATE-PROVIDED benefits

INTERNAL ISSUES
8. the company may have suffered REPUTATIONAL issues
9. it may have POOR SERVICE STANDARDS
10. there may have been adverse press comment.
11. There has been a recent increase in underwriting standards which has caused a barrier to entry

Question 160

Factors to consider before reducing premiums if new business rates are falling (8)

Answer 160

1. Consider whether the premium rates are still profitable
2. Consider a loss leading or marginal costing method to aim to sell higher volumes
3. Reaction of competitors
4. Reinsurance
5. If the company already has reinsurance- the reinsurer may need to be involved in the decision making
6. Consider adding features to make the product more attractive
7. Offer additional sales support or marketing
8. Take action that directly addresses the reason for the fall in new business e.g., repair reputation or improve customer service

Question 161

The advantages of PAYG (5)

Answer 161

1. Allows benefits to be introduced at a worthwhile level in the early years as there is no need to wait for a fund to accumulate
2. involves LOWER TRANSACTION COSTS (as there is no funding)
3. prevents funds from being TIED UP in the scheme (and so not being available for other uses
4. can INCREASE SOLIDARITY within the community, if a state-operated scheme (the contract between generations whereby the working generations finance the pensions of the retired)
5. makes it easier to organise payment according to need, with contributions according to ability to pay.

Question 162

Advantages of funding in advance (7)

Answer 162

1. provides SECURITY FOR MEMBERS and hence meets paternalistic aims of employer
2. may be required by REGULATION
3. TAX INCENTIVES may be given on contributions and/or investment returns, making funding in advance attractive
4. COMPETITORS schemes may be funded in advance and therefore this scheme may need to follow suit to make it attractive to new and existing staff
5. if an appropriate funding method is chosen, e.g. regular contributions, then LIQUIDITY CONCERNS can be EASED …
6. … and the employer will have some degree of FLEXIBILITY in relation to the TIMING of CONTRIBUTION
7. a single premium at inception might be able to be invested at a known yield to provide appropriately timed cashflows, thereby AVOIDING REINVESTMENT RISK and REDUCING COSTS.

Question 163

Disadvantages of funding in advance (3)

Answer 163

1. OPPORTUNITY COST of investing money in the pension scheme rather than in the business
2. method must be chosen carefully, as some methods may require significant funds to be found at certain points in time (e.g. lump sum in advance)
3. not all methods give a REALISTIC ASSESSMENT of COST.

Question 164

Factors to assess in choosing a financing method: (11)

Answer 164

STROLLERS FC

1. Security of the benefits (members / trustees)
2. Tax incentives
3. Realism - a funding plan with low contributions now and high contributions later may give the sponsor an unrealistic view of the cost of the benefits in the short term.
4. Opportunity cost (sponsor) - as the monies could be used by the sponsor on other projects.
5. Liquidity / cashflow (sponsor) -There may be liquidity problems with pay-as-you-go if the sources of income are not particularly liquid or if there is an unexpectedly high level of benefits to pay relative to the cash available.
6. Legislation
7. Expenses - will incur different levels of administration and transaction cost.
8. Risk allocation - between the members and the sponsor.
9. Stability of contributions (sponsor)
10. Flexibility of contributions (sponsor)
11. Competitors

Question 165

Components that should be considered when determining the likely cost of each risk, under the risk financing stage of the risk management control cycle (4)

Answer 165

1. The cost of putting in place INTERNAL RISK CONTROL MEASURES
2. The cost of TRANSFERRING risk to another party, e.g. insurance premium
3. The EXPECTED COST of RISK EVENTS occurring in respect of risks that are retained
4. The cost of HOLDING CAPITAL against adverse outcomes in relation to the risks that are retained.

Question 166

Advantages of managing risk at the business level (4)

Answer 166

• If risk is managed at the business level, then the parent company decides on its overall risk appetite and then divides this between the business units.
•The management of each business unit then manages the risks of the business within the allocated risk appetite.
1. Therefore each business unit feels a SENSE of RESPONSIBILITY/ DIRECT INVOLVEMENT in RISK MANAGEMENT .
2. The management teams of the various business units are MORE CLOSELY involved in UNDERSTANDING THE RISKS and how to deal with them.
3. Relatively easy and cheap to implement
4. Should be easy to understand

Question 167

Advantages of managing risk at the enterprise level (5)

Answer 167

•If risk is managed at the enterprise level, then a group risk management function is established.
•The risks of the various business units are identified and then the results combined into a risk assessment model at the entity level.
•Enterprise risk management involves considering the risks of an enterprise as a whole, rather than considering individual risks in isolation.
1. This approach makes allowance for the BENEFITS of DIVERSIFICATION or POOLING OF RISK.
2. It provides INSIGHT, at a group level, into the areas with UNDIVERSIFIED RISK EXPOSURES or TOO MUCH CONCENTRATION of risk, where the risks need to be transferred or sufficient capital set aside to cover.
3. Such an approach is important in ensuring EFFICIENT CAPITAL USE across the group.
4. More effective in enabling a company to TAKE ADVANTAGE of OPPORTUNITIES to add value.
5. Understanding risk better across the whole enterprise can allow the company to TAKE GREATER RISKS in order to increase returns.

Question 168

Factors that affect the risk appetite of a company (11)

Answer 168

1. Existing exposure to the risk
2. The culture of the individual / company.
3. Size of company
4. Structure of the business (public vs private company, mutual company)
5. Capital available & level of free assets
6. Existence of a parent company/other guarantors
7. Period of time for which it has operated
8. Level of regulatory control to which it is exposed
9. Previous experience of the board members
10. Attitude to risk of owners and other providers of capital
11. Company’s preference to maintain a certain credit rating

Question 169

Measures that can be used to measure/express risk appetite

Answer 169

Can be expressed by means of both quantitative as well as quantitative statements.
1. Solvency level
- staying above a certain threshold with a certain probability.
- Probability of ruin might also be a valid metric to consider
2. Credit rating
- ..with the rating not reducing beyond a certain level with a certain level of confidence
3. Earnings and ability to pay dividends
- …..e.g. earnings volatility not exceeding X.
4. Economic value
- ..e.g. not losing a certain amount of economic value (or earnings) with a given probability.
- …(e.g. only 1/200 year outcomes should exceed the risk appetite for example).

Qualitative statements may refer to risks that the company chooses to avoid altogether,.
..e.g. not doing business with anyone that has a criminal record…
..or avoiding doing business in certain territories or with certain organisations.

Question 170

Properties and desirable criteria of an insurance risk (9)

Answer 170

1. Policyholder has insurable interest in the risk
2. The risk is of a financial and reasonably quantifiable nature
3. The claim accounts payable bears some relationship to the financial loss
4. Individual risks should be independent
5. The PROBABILITY of the event occurring would be relatively SMALL
6. Large numbers of similar risks should be POOLED to reduce variance
7. There should be a limit on ultimate liability undertaken
8. Moral hazard should be eliminated as far as possible
9. There should be sufficient existing data/information in order to quantify risk

Question 171

Identification of causes of risk in projects (7)

Answer 171

(Preston North End Football Club Plays
Brilliantly)

1. Political risks
2. Natural risks
3. Economic risks
4. Financial risks
5. Crime
6. Project risks
7. Business risks

Question 172

How is inappropriate advice given to consumers? (6)

Answer 172

CRIMES
1. Complicated products
2. Rubbish (ie incompetent) adviser
3. Integrity of adviser lacking, eg due to sales-related payments
4. Model or parameters unsuitable
5. Errors in data relating to beneficiaries
6. State-encouraged but inappropriate actions

Question 173

Importance of risk reporting (10)

Answer 173

1. IDENTIFYING new risks
2. QUANTIFYING the impact of individual risks
3. determining appropriate CONTROL systems for specific risks
4. MONITORING the effectiveness of existing control systems
5. assessing CHANGES to risks faced
6. assessing the INTERACTION between risks
7. assisting with pricing, reserving and determining capital requirements.
8. gives a greater understanding of attractiveness to INVESTORS
9. helps CREDIT RATING AGENCIES to determine an appropriate rating
10. helps REGULATORS understand areas that require more scrutiny

Question 174

Risk responses (6)

Answer 174

1. Avoid
2. Reduce/mitigate
3. Reject
4. Retain
5. Transfer in full
6. Partially retain and partially transfer

Question 175

Evaluation of risk mitigation options (4)

Answer 175

1. Impact on frequency / severity / expected value
2. Feasibility of implementation
3. Cost and impact on profit
4. Secondary risks and Mitigation required in response to secondary risks

Question 176

Extent of risk transfer depends on (4)

Answer 176

1. PROBABLILITYof the event occurring
2. RISK APPETITE and existing resource to finance the risk event if it happens
3. COST of transferring the risk
4. Willingness of a third party to accept the risk

Question 177

Reasons for reinsurance (12)

Answer 177

VOLATILITY OF PROFITS PROTECTION
1. Protection against the impact of very large individual claims
2. Protection against poor experience in a class of policies (acc risk)
3. smooth profits by removing cyclical variability
4. Removal of concentration risk (geographical and portfolio)
5. Catastrophe protection (limitation of large losses arising from a single event)
CAPITAL REASONS
6. Reduces capital requirements
7. Increases capacity to write larger risks
8. Increases capacity to write more business
9. Balance sheet efficiency - can remove/reduce a key risk
10. Regulatory arbitrage
Therefore, reduces probability of insolvency
11. EXPERTISE
12. DIVERSIFICATION

Question 178

Advantages of quota share reinsurance (6)

Answer 178

1. Spreads risk
2. Enables insurers to write larger portfolios of risk
3. Encourages reciprocal business
4. Directly helps improve the solvency ratio and helps the insurer to satisfy the statutory solvency requirement
5. Administratively simple
6. Commission may help with cashflow

Question 179

Disadvantages of quota share (4)

Answer 179

1. Inflexible as it cedes the same proportion of low-variance and high-variance risks
2. Cedes the same proportion of each risk, irrespective of size.
3. Not good at protecting against catastrophes or very large claims because it does not cap the cost of very large claims
4. Passes a share of any profit to the reinsurer

Question 180

Advantage of surplus reinsurance (3)

Answer 180

1. Enables an insurer to write larger risks
2. It is flexible and enables the ceding provider to ‘fine-tune’ its experience for the class concerned
3. Helps the ceding provider to spread the risk

Question 181

Disadvantages of surplus reinsurance (2)

Answer 181

1. Administration is more complicated than for quota share
2. Does not cap very large claims

Question 182

Advantages of excess of loss
(XoL) reinsurance (4)

Answer 182

1. Caps losses
2. Protects cedants against from a catastrophe, a large claim or an aggregation of claims that could lead to insolvency
3. Stabilises the technical results of the insurer by REDUCING CLAIM FLUCTUATIONS
4. Helps make more efficient use of the capital by REDUCING the VARIANCE of the claim payments

Question 183

Disadvantages of excess of loss (XoL) reinsurance (2)

Answer 183

1. In the long run: If priced correctly by the reinsurer, the reinsurance premium paid by the insurer will be greater than the expected recoveries under the treaty since the reinsurer has loaded the premium for expenses, profit and contingency margins
2. From time to time, XL premiums may be considerably greater than the pure risk premium for the cover

Question 184

Uses for integrated risk covers (3)

Answer 184

1. Avoid buying excessive cover
2. smooth results
3. lock in attractive terms

Question 185

Advantages of integrated a risk covers (3)

Answer 185

1. Cost savings —>no longer the need to negotiate several separate reinsurance arrangements
2. Greater stability of results due to diversification by type of risk insured and a time
3. They can be used as a substitute for debt or equity in the investment portfolio of the original insurer

Question 186

Disadvantages of integrated a risk covers (4)

Answer 186

1. Credit risk
2. lack of availability
3. expenses arising from the tailor-made aspect
4. difficulty in structuring the providers risk management programme

Question 187

Advantages of securitisation (3)

Answer 187

1. No credit risk
2. Uncorrelated with typical market related risks therefore capital markets may require a lower return compared to reinsurers
3. Less ongoing admin

Question 188

Disadvantages of securitisation (3)

Answer 188

1. Too high an expected return might need to be embedded into the bonded to make it attractive to investors therefore the bond won’t be liquid
2. investors might be concerned about information asymmetry
3. more admin and effort initially with design and getting it in the market

Question 189

General benefit risks: (6)

Answer 189

1. Sponsor default
2. Failure by sponsor to pay contributions on time
3. Takeover of the sponsor
4. Decision by the sponsor to reduce benefits
5. Inadequate communication with beneficiaries
6. General economic mismanagement by sponsor

Question 190

Contribution risks for contributions that are not known in advance (4)

Answer 190

1. Future contributions unknown and depend on:
   • the amount of benefit
   • eligibility to accrue benefits
   • eligibility to receive benefits
   • inflation
   • investment return net of tax and expenses
2. Extra contributions may be required to meet a SHORTFALL, resulting in liquidity risk or excessive contributions
3. TAKEOVER by third party not willing to continue contributions
4. Extra costs incurred through the provision of guarantees

Question 191

For both a DB and a DC, further contributions may be required due to (7)

Answer 191

1. loss of funds due to fraud or misappropriation
2. incorrect benefit payments
3. Inappropriate advice
4. administrative costs, e.g. to comply with changes in legislation
5. decisions by parties to whom power has been delegated
6. fines or removal of tax status resulting from non-compliance with legislation
7. changes to tax rates or status.

Question 192

Reasons why an individual may receive a lower pension than anticipated in a DC scheme: (15)

Answer 192

Less is paid in contributions than expected due to:
1. salary increases being less than expected
2. the individual taking career breaks
3. the individual retiring earlier than expected
4. net invested contributions being less than expected due to higher charges.

Lower investment return is achieved than expected due to:
5. under-performance of assets leading to lower than expected investment income
6. under-performance of assets leading to lower than expected capital growth
7. contributions being paid later than expected, so there is less time to earn investment returns
8. a fall in market values at the time that the pension annuity is purchased
9. investment expenses (or fund-related charges) being greater than expected.

The pension annuity purchased may cost more than expected, due to:
10. a fall in the investment return the annuity provider expects to receive post-retirement, i.e. fall in bond yields
11. improving mortality, so more benefit payments are expected to be made
12. a change in the type of annuity purchased, for example:
* inclusion of spouse pension
* inclusion of pension increases
13. expense and profit allowances in the cost of the annuity may be greater than expected.

14. The member may choose to take some of the fund as cash, so less money is available to purchase the annuity.
15. There may be changes to regulation that affects benefits.

• from Sasha, the member could be withdrawing income from their fund on retrenchment

Question 193

How an individual can mitigate against inappropriate advice: (12)

Answer 193

1. Check that the advisor is appropriately QUALIFIED.
2. Only use a financial advisor who has been recommended by a TRUSTED SOURCE.
3. Carry out RESEARCH of their own before consulting the advisor (so as to be better equipped to understand and question the advice given).
4. Look for an advisor who operates on a FEE BASIS, rather than using commission.
5. Make sure that the product sold incorporates a COOLING-OFF PERIOD (so that the policy can be cancelled during an initial period if it is found that inappropriate advice has been given).
6. Seek a wide range of quotes for COMPARISON.
7. Be HONEST ABOUT their NEEDS, state of health and financial position (so that the advisor has the correct data with which to offer advice).
8. Make sure that they are FINANCIALLY AWARE.
9. QUESTION government advice.
10. Read the SMALL PRINT.
11. Check their UNDERSTANDING of the product before committing to purchase.
12. If the individual discovers that inappropriate advice has been given, then they could write to the regulator or ombudsman in pursuit of COMPENSATION.

Question 194

Climate risks for a health insurer (6)

Answer 194

Physical risks:
1. damage to property
Liability risks:
2. higher sickness claims rates due to food shortages… or due to a greater spread of disease and access to water
3. higher injury claims rates due to more natural disasters and extreme weather events
Transition risks:
4. disruption to financial markets as a result of more natural disasters and extreme weather events.
5. fall in value of investments in companies
6. higher than expected costs of updating own operations to meet environmental targets

Structure
Asked for climate risks: 1. Physical 2. Liability 3. Transitional

Question 195

How to assess the security of a reinsurer (4)

Answer 195

1. The insurer should start by looking at the FINANCIAL STRENGTH of the reinsurer.
   • The reinsurer’s published accounts and statutory returns would be a good starting point.
   ➡️ SOLVENCY POSITION, i.e. the level of free assets
   ➡️ TYPES OF ASSETS HELD - match for liabilities, cashflow, volatility, diversification, marketability and liquidity
   ➡️ BORROWINGS - level of gearing, income and asset cover.
2. The LEGISLATIVE ENVIRONMENT in which the reinsurer operates will also affect solvency.
3. The TYPE OF BUSINESS that the reinsurer writes will affect the security of the reinsurer.
   * With regard to the REINSURER’S LIABILITIES, the insurer should look at:
   ➡️ the diversity by class, geographical region and cedant
   ➡️ exposures to any risk accumulations / catastrophes
   ➡️ any particularly large, unusual or volatile risks covered by the reinsurer
   ➡️ the size of the liabilities and future plans for development / expansion
   ➡️ whether the reinsurer itself has reinsurance.
4. The REPUTATION of the reinsurer, for example:
   ➡️ its market share
   ➡️ its previous claims history
   ➡️ the ability of the management
   ➡️ whether the reinsurer has a parent company or is associated with other companies and how financially strong these are
   ➡️ its credit rating
   ➡️ the views of others in the industry: other insurers, analysts, the regulator, etc.

Question 196

Factors determining the amount and type of reinsurance required (16)

Answer 196

1. Achieving a balance between the benefit of reinsurance and the cost of reinsurance
2. Potential benefits that reinsurance would need to include e.g., reduced volatility in claims would determine the type
3. Management and shareholders attitude to risk (shareholders may prefer more stable results and hence stable dividends)
4. Current capital position (free assets etc)… to ensure that the reinsurance arrangements address any realistic threats to their capital.
5. The need for any arrangements to be simple and practical
6. It may be useful to enquire from the reinsurer to understand what the rest of the market is doing.
7. The reinsurer may insist on a minimum level of business. Especially if
   they are offering technical assistance in return

FUDGE ACTORS

F- size of the insurers Free reserves
- Financial strength
U- Underwriters influence
D- size and Diversification of the insurers portfolio
G- Geographical location
E- the need for technical assistance on the reinsurance experience (Expertise)

A- Accumulation of risk
C- Class of business
- Cost and availability of reinsurance
- impact on Capital management
T- Tax advantages
O- financial Objectives
R- Risk appetite and tolerance
- Regulatory requirements and fiscal regime
-the reinsurance requirements for a minimum Retention of risk or collection of risks
- Relationship with The insurers and brokers

Question 197

Reasons why insurers take out ART contracts (9)

Answer 197

ACCESS TMD

1. Provision of cover that might otherwise be unavailable (Availability)
   — securitisation, post-loss funding, swaps, derivatives are arranged through other markets.
2. Cheaper cover
   • Securitisation - insurance risk is uncorrelated with typical market-related risks, the capital markets may require a lower return on capital than reinsurers.
   • integrated risk covers
   — reinsurer is obtaining a multi-line (diversified) portfolio of business, it may be happy to offer more favourable terms than if the individual risks were priced separately.
   — Cost savings arise because there is no longer the need to negotiate several separate reinsurance arrangements, and because the covers do not need to be renegotiated every year.
3. source of Capital
4. More Effective provision of risk management
5. Stabilisation of results
   — Integrated risk covers provide multi-line, multi-year reinsurance, which stabilises the cedant’s results.
   — Increased diversification will act to reduce volatility.
6. greater Security of payment
   • capacity of the capital markets tends to be greater than that of reinsurers, resulting in a lower likelihood of default.
   • Under securitisation, e.g. a catastrophe bond, the capital is provided to the insurer up-front.
7. Tax advantages
8. Management of Solvency Margins-reduction of risk allows a lower risk-based capital requirement to be held
9. Diversification
   — exposure to counterparties other than reinsurers

Question 198

Reasons for underwriting (7)

Answer 198

1. It can protect a provider from ANTI-SELECTION
2. It enables a provider to CLASSIFY RISKS into homogenous groups for which a STANDARD PREMIUM can be charged, and thus helps to ensure that all risks are RATED FAIRLY.
3. It enables a provider to identify risks for which SPECIAL TERMS need to be quoted.
4. For substandard risks, the underwriting process IDENTIFIES THE MOST SUITABLE APPROACH and level for the special terms to be offered.
5. It helps in ensuring that claim experience DOES NOT DEPART TOO FAR from that assumed in the pricing of the contracts being sold.
6. For larger proposals, it will help to reduce the risk from OVER-INSURANCE.
7. Identify lives in such poor health that it should not give them cover

Question 199

Types of underwriting (3)

Answer 199

1. Medical underwriting
2. Lifestyle underwriting
3. Financial underwriting

Question 200

Special terms offered after underwriting (4)

Answer 200

1. an addition to the premium
2. a reduction to the benefit
3. an exclusion clause
4. declining the applicant (either on a temporary or permanent basis).

Question 201

Why would a company decline a high risk rather than charging an extremely high premium (3)

Answer 201

1. Difficult to rate them accurately
2. Risk of claiming may be so high that there is little hope of recouping the initial expenses involved
3. The appropriate premium might be so high that there is no realistic hope of selling the policy

Question 202

Bank underwriting activities (4)

Answer 202

1. Assessment of the customers willingness and capacity to repay a loan
2. Credit history and past performance
3. Customer identity and income verification
4. Credit bureau data

Question 203

Special terms after bank underwriting (3)

Answer 203

1. Charge a higher rate of interest
2. Reduce loan amount
3. Provide an asset as surety

Question 204

Claims management control systems include: (4)

Answer 204

1. data recording - enable proper provisions are established and reduce the operational risks from having poor data
2. accounting and auditing- enable proper provisions to be established, regular premiums to be collected
3. monitoring of liabilities taken on - protect the company against aggregation of risks of a specific type to an unacceptable level
   — important to monitor the amount of new business to ensure that it’s within the company’s available capital resources
4. Management of options and guarantees
   — managed using eligibility criteria and asset-liability matching

Question 205

Techniques for managing options and guarantees (2)

Answer 205

1. liability hedging and asset-liability matching, including the use of derivatives and dynamic hedging
2. Restricting option eligibility

Question 206

Factors affecting the choice of basis and valuation method when determining the value of an insurer’s liabilities (9)

Answer 206

1. the reason for (or purpose of) the valuation
2. the needs of the client and their risk appetite
3. regulation and legislation.
4. Type of business and the risk management strategy of the provider
5. Risk characteristics of business
6. Quality and quantity of the data are used
7. Possibly, the nature of the assets
8. If for a transfer of liabilities, the relative negotiating power of the parties whether the valuation assumes a going concern or a break-up basis.
9. If being valued for supervisory solvency purposes, the size of the solvency capital (e.g. the larger the solvency capital the less significant the margins in the individual provisions may be)

Question 207

Considerations used for valuing options and guarantees (4)

Answer 207

1. the state of the economy (and hence must be scenario specific)
2. demographic factors such as age, health and employment status
3. cultural bias
4. customer sophistication.

Question 208

Sensitivity analysis can be used to: (2)

Answer 208

1. To help determine the extent of the margins needed in assumptions, to allow for adverse future experience
2. to determine the extent of any global provisions required.

Question 209

How to allow for risk using a discounted cashflow valuation (3)

Answer 209

1. build a MARGIN INTO EACH ASSUMPTION
2. apply an OVERALL CONTINGENCY LOADING by increasing the liability value by a certain percentage
3. Adjust the DISCOUNT RATE to reflect the risk in the project or liability

Question 210

How to allow for risk using a fair valuation (2)

Answer 210

1. no need to adjust for financial risk (already implicitly allowed for)
2. for non-financial risk:
   
   • adjust the cashflows (or discount rate)
   • hold an extra provision or capital requirement such as the Solvency II risk margin

Question 211

Different methods of calculating provisions (3)

Answer 211

1. STATISTICAL ANALYSIS- if there are many claims, following a known pattern
2. CASE-BY-CASE ESTIMATE - individual assessment of claim records where there are few claims
3. PROPORTIONATE APPROACH- based on amount of net premium yet to expire.

Question 212

Factors that underwriting has on pricing (6)

Answer 212

The stricter the underwriting:
1. the lighter the EXPECTED CLAIMS EXPERIENCE-bad risks are likely to be deterred by high levels of underwriting
2. the higher the underwriting EXPENSES.

Affects:
3. the level of ANTI-SELECTION
4. the TARGET MARKET
5. the level of SELECTIVE WITHDRAWAL
6. the PROVISIONS - better the risk management process, the lower the level of global provisions that may be required, and the lower the charge for cost of capital / provisions within pricing.

Question 213

Affect of decreasing underwriting (11)

Answer 213

SHORT-TERM
1. Sales may rise, … (lower barrier to entry)
2. … which would, all else being equal, increase profits.
3. Underwriting costs may be slightly lower.
-The company could pass on some or all of this saving to customers through lower premiums, making the product more competitive.
4. Processing of policies should also now be faster
5. Lapse and re-entry problems from lives that were originally, for example, charged extra due to the answers given to the now-removed questions.
LONG-TERM
6. Higher sales may put a strain on the capital resources of the company
7. Greater selection against the company.
8. So the mortality experience may rise, meaning that the premium rates should increase considerably.
9. This may cause the good lives to leave, leading to a spiral of worsening experience (as the company is left with poor lives, so mortality experience worsens, etc.).
10. There is less chance for the underwriter to get the premium rate right (less data) —> uncertainty leads to bigger margins and higher premiums
11. Higher provisions

Question 214

How to manage a low likelihood, high impact risk? (5)

Answer 214

1. Diversification - can only be diversified in a limited way
2. Transferred to an insurer or reinsurer
3. Implement management control procedures, e.g. a disaster recovery plan.
4. Risk might have to be accepted, and the company would then have to determine how much capital to hold against it.
   —ensure not too much weight is placed on such a risk at the expense of dealing with other more common risks to the business
5. Avoid e.g., if the risk is an earthquake, consider relocating

Question 215

Purposes of risk controls (4)

Answer 215

1. Reduce the likelihood of a risk event occurring
2. Limit the severity of the effects of a risk event that does occur
3. Limit the financial consequences of a risk
4. Reduce the wider consequences of a risk event that does occur

Question 216

Control of exposure to longevity risk (7)

Answer 216

1. MONITOR its mortality experience and UPDATE its annuity rates regularly to allow for the latest mortality experience, …
2. … including expectations of future improving longevity rates.
3. Pricing should include a MARGIN for prudence / risk.
4. DIVERSIFY its longevity risk exposure by trying to move into other markets with new products that have mainly mortality risk.
   —For the best match, it is necessary to look for products that match the age and duration of the annuitant longevity risk.
5. The company could pass risk to a REINSURER or enter into a RECIPROCAL arrangement with another insurer.
6. Use ART’s
   — longevity swap
   —longevity bond
   —securitisation
7. Better UNDERWRITING

Structure
When asked for controls, think of transferring risk; diversification of risk; mitigation…

Question 217

The advantages of the assumptions for valuing a benefit scheme being prescribed by legislation (4)

Answer 217

1. ensures consistency between different schemes
2. ensures consistency between actuaries
3. ensures consistency over time
4. may aim to ensure that appropriate assumptions are used

Question 218

The disadvantages of the assumptions for valuing a benefit scheme being prescribed by legislation (2)

Answer 218

1. the assumptions may not be suitable for valuing all schemes
2. the assumptions may become outdated over time

Question 219

The advantages of the assumptions for valuing a benefit scheme being left to actuarial judgement with a requirement for disclosure (4)

Answer 219

1. allows actuaries to include factors that are specific to the individual scheme
2. allows actuaries to exercise their professional judgement
3. can easily be updated over time
4. the requirement for disclosure ensures accountability

Question 220

The disadvantages of the assumptions for valuing a benefit scheme being left to actuarial judgement with a requirement for disclosure (2)

Answer 220

1. assumptions may not be appropriate and may be manipulated
2. there will be costs if the regulator checks the appropriateness of the assumptions used.

Question 221

Factors that will affect the basis used for the transfer between the two schemes (5)

Answer 221

1. It is important to set a basis that both the transferring and receiving parties view as being FAIR.
2. The actuaries representing the two companies will need to determine the basis between them:
   • The actuary of Scheme B will be keen for an optimistic basis to be used so that a low value is paid to Scheme A in respect of the transferring liabilities.
   • The actuary of Scheme A will be keen for a prudent basis to be used so that Scheme A receives a payment that places a high value on the transterring liabilities.
3. A BEST ESTIMATE BASIS might be viewed as fair to both parties.
4. The extent to which the basis moves away from best estimate will reflect:
   a. Which party has the greater NEGOTIATING STRENGTH . It also will reflect any concessions made elsewhere in the overall deal.
   b. The desire by Company A to off-load the liabilities or by Company B to take the liabilities
   on.
   c.There may also be recognition of a need to hold a MARGIN to protect the security of the benefits.
5. The basis needs to allow for the EXPENSES associated with the transfer

Question 222

Information in a company’s report (6)

Answer 222

1. Performance against key objectives
2. Investment strategy and performance
3. Progress against long- and short-term strategic goals/ objectives
4. Attitude to risk, key risks faced, risk management and mitigation
5. Governance arrangements, including independence of the Board
6. Statement from chairperson & CEO that focus on performance against objectives & any exceptional events that has happened during the period(eg.

Question 223

Insurance companies rarely become insolvent because: (2)

Answer 223

1. A REGULATOR typically regularly monitors the financial position of insurance companies
2. Insurance company regulation typically requires companies to hold a minimum level of SOLVENCY CAPITAL.

Question 224

if the insurer’s financial position is serious (e.g. the solvency capital requirement is not met), then the regulator may require the company to: (2)

Answer 224

1. Close to new business
2. Establish a recovery plan (with implementation monitored closely by the regulator).

Question 225

What does a recovery plan (if solvency capital is not met) entail? (3)

Answer 225

1. Changing the investment strategy to invest in assets that better match the liabilities
2. Increase the amount of reinsurance
3. Limiting the levels of new business sold

Question 226

When projecting the insurer’s solvency position into the future, what issues need to be addressed and modelled: (6)

Answer 226

1. Estimation of future post-tax profits available to equity shareholders
2. The current value of all surplus assets
3. The amount, and timing, of any loan or debt redemption
4. Problems relating to industrial relations (including redundancies)
5. Issues relating to any staff benefit schemes - particularly if in deficit
6. Outstanding financial obligations, minority interests and tax.

Question 227

If a scheme ceases, the level of benefits that will be paid will be affected by the: (3)

Answer 227

1. Rights of the beneficiaries
   — Right to the benefits that have been or should already have been received
   — Right to what they would receive if they remained in the scheme until retirement and continued to accrue benefits
2. Expectations of the beneficiaries, e.g., include:
   — Future accrual of benefits
   — Future growth
   — Any discretionary benefits
3. The level of assets

Question 228

If a benefit scheme is being discontinued, the following options may exist for the provision of the outstanding benefit payments: (6)

Answer 228

1.Continuation of the scheme without any further accrual of benefits
2. Transfer of the liabilities to another scheme with the same sponsor
3. Transfer of the funds to the beneficiary, in cash form if permitted by legislation or as a transfer to an insurance company or to the scheme of any new employer
4. Transfer of the funds to an insurance company to invest in a group or individual
pension accrual policy (without guarantees)
5. Transfer of the liabilities to an insurance company to guarantee the benefits
6. Transfer of the liabilities to a central discontinuance fund (national or industry-wide).

Question 229

A bank may become insolvent when: (2)

Answer 229

1. A bank is unable to meet its obligations to its depositors and creditors,
2. A bank’s value of its assets falls below the value of its liabilities.

Question 230

What to consider when valuing provisions for guarantees (5)

Answer 230

1. In general, when determining the provisions for guarantees, a CAUTIOUS APPROACH should be taken.
2. Providing the WORST CASE SCENARIO for every contract will mean that unnecessary provisions are made
3. Use a STOCHASTIC APPROACH to value guarantees to estimate the likelihood of the guarantee biting
4. The output can be used to work out the likelihood of the guarantee biting as well as key statistics such as the expected cost and the variability of the cost of the guarantee.
5. If a parameter is modelled (e.g., withdrawal rate) stochastically - it might be difficult to model because they are a consequence of human behaviour and are influenced by economic conditions. Investment return assumptions are a better variable to model stochastically

Question 231

What to consider when valuing options (3)

Answer 231

1. It is not always appropriate to assume that the highest cost option is exercised.
2. The risk of anti-selection must be allowed for when valuing options.
3. An option within liabilities can be valued by finding a market option that replicates it. A closed form approximation may be used, eg Black-Scholes.

Question 232

Advantages of the traditional discounted cashflow approach (2)

Answer 232

1. Consistency and stability
   the use of a consistent long-term discount rate to value both assets and liabilities gives:
   • consistency in the valuation of assets and liabilities, and
   • stability to the result over time.
2. Actuarial judgement
   The discounted cashflow approach enables the actuary to bring in the benefit of judgement, whereas a fair value approach in its purest form does not.

Question 233

Disadvantages of the traditional discounted cashflow approach (3)

Answer 233

1. Purpose
   —might not be deemed to represent a sufficiently fair value for some purposes, such as a discontinuance valuation or a transfer between pension schemes given that these are SHORT-TERM VALUATIONS and the traditional discounted cashflow approach is based on long-term assumptions.
2. Actuarial judgement
   —can be viewed in a negative light as introducing subjectivity.
3. Doesn’t reflect actual assets held. It placed a different value on assets from the market value, which introduces an additional element of risk

Question 234

Advantages of the fair value approach (2)

Answer 234

1. Practicalities
   It will be easier to explain the valuation of assets to clients if a fair value approach is used, since assets are valued at market value
2. International accounting standards have instigated a move towards a fair value method of valuation.

Question 235

Disadvantages of the fair value approach (2)

Answer 235

1. More volatility
   — under a fair value replicating portfolio approach, there may be more volatility depending on the extent to which the ACTUAL ASSETS HELD CORRESPOND WITH THE MATCHING PORTFOLIO used to determine the value of liabilities.
   — If a risk-neutral market-consistent valuation approach is used, then volatility will arise to the extent that ACTUAL INVESTMENT PERFORMANCE DIFFERS FROM THEN RISK-FREE RATE.
2. Practicality
   —assets are difficult to price and sometimes a market value does not exist or does not reflect a sufficiently deep and liquid market for it to be deemed to be a ‘fair’ value.

Question 236

Advantages of using best estimate assumptions and an explicit contingency loading compared to margins in individual assumptions (3)

Answer 236

1. The degree of caution introduced can clearly be identified.
2. It avoids the need to take care when introducing individual margins within the basis to ensure that margins in different assumptions don’t cancel out or alternatively that many small margins lead to a basis which is too strong.
3. The approach may be easier to explain to clients. In contrast, using lots of individual prudent assumptions lacks transparency and can be harder to explain to clients compared with a single explicit contingency margin.

Question 237

Disadvantages of using best estimate assumptions and an explicit contingency loading compared to margins in individual assumptions (2)

Answer 237

1. It is difficult to assess the appropriate allowance to be made.
2. Margins have not been targeted to the areas where they are required.

Question 238

The disadvantages to a general insurance company of needing to carry out case-by-case estimates as opposed to a statistical analysis to calculate the provisions. (4)

Answer 238

1. It is time-consuming and therefore expensive.
2. There is a risk that the case assessors may not have sufficient expertise, leading to incorrect assessment.
3. The process is subjective and there is a risk of bias by the assessors.
4. This approach can only look at reported claims; a separate approach will be needed to evaluate incurred but not reported claims.

Question 239

Main purposes of the actuarial valuation of a benefit scheme (2)

Answer 239

1. Demonstrate solvency
2. Determine the future contribution rate required

Question 240

Reasons for lower commission ratio (2)

Answer 240

Commission ratio=commission paid/written premiums

1. The insurer has lowered its commission levels with no change in premium rates or sales.
2. The mix of business may have changed in some way. For example, the insurer might be selling more business from a sales channel which is paid lower commission

Question 241

Reasons for the lower outward reinsurance ratio (4)

Answer 241

Proportion reinsured= net premiums written/gross premiums written

1. The cost of reinsurance has increased.
2. The insurer has increased its premium rates and the number of policies sold has fallen as a result, leading to lower total premium income.
3. The premium rates are unchanged but the number of policies sold has fallen and so total premium income has fallen anyway.
4. The insurer is buying greater volumes of reinsurance relative to business written.

Question 242

Reasons for an increase in the probability of default and loss given default on a banks loan portfolio (5)

Answer 242

1. A shift in the balance of the portfolio towards LESS SECURE BORROWERS, possibly due to a change in marketing strategy towards borrowers in lower socio-economic groups
2. a RECESSION:
   — so LOWER COMPANY PROFITS are anticipated and therefore higher expected defaults on commercial loans
   — so HIGHER UNEMPLOYMENT is anticipated and therefore higher expected defaults on personal loans
3. higher INTEREST RATES, leading to expectations of higher defaults on variable rate loans due to unaffordable interest payments
4. a FALL IN PROPERTY VALUES …
   … which could increase the expected loss given default on mortgages if it leads to negative equity (i.e. the property value not covering the amount owed)
5. some SIGNIFICANT ACTUAL DEFAULTS, leading to increased uncertainty or concern in terms of the expectation of further defaults.

Question 243

Disclosures to beneficiaries of benefit schemes (6)

Answer 243

1. benefit entitlements
2. contribution obligations
3. expense charges
4. investment strategy
5. risks involved
6. treatment of entitlements in the event of insolvency.

Question 244

Disclosures in company accounts of a benefit scheme (10)

Answer 244

1. assumptions
2. actuarial method
3. value of liabilities accruing over the year
4. increase in the past service liabilities over the year
5. investment return achieved on the assets over the year
6. surplus or deficit and the change in this figure over the year
7. benefit cost over the year in respect of any directors
8. Membership summary…
9. ..Along with any membership movements.
10. Expense breakdown

Question 245

Reasons why a sponsor might decide to stop financing its benefit scheme (4)

Answer 245

1. a NEW SCHEME has been set up, with existing members being transferred into the new scheme for future accrual instead of continuing to accrue benefits in the existing scheme
2. the sponsor wishes to follow market TREND in benefit provision
3. the sponsor does not want to finance any future benefit provision, for example, because:
   —the COST and BENEFIT BALANCE has changed (e.g. a change in legislation has significantly increased the cost of providing a scheme)
   —the costs and benefits are themselves unchanged, but the SPONSOR’S VIEWS have changed
   —the sponsor needs to REDUCE COSTS in order to continue to operate
4. the sponsor has become INSOLVENT .

Question 246

How to reduce the risk of insolvency (14)

Answer 246

MAXIMISE THE VALUE OF ASSETS
1. Choose an optimal investment strategy that maximises return, subject to an acceptable degree of risk.
2. Hold assets that have maximum value in the solvency test
3. Raise new capital
MINIMISE THE VALUE OF LIABILITIES AND SOLVENCY CAPITAL
4. Reduce exposure to unusual and significant claim events e.g., large individual claims
5. Write less of classes where experience is very uncertain- and hence particularly conservative reserves
6. Restrict exposure to certain perils, through exclusions or upper limit on payouts.
7. Purchase appropriate types and levels of reinsurance cover
8. Use a weaker basis for valuing liabilities.
9. Apply more stringent underwriting and claims control.
10. Impose tighter insurance operational risk management,
11. Reduce risk through increased diversification of business.
12. Restrict new business volumes, if there is new business strain.
GIVE STABILITY TO THE RELATIVE VALUE OF ASSETS TO LIABILITIES
13. The investment policy should aim to match assets and liabilities by nature, term, currency and predictability
14. The suitability of the pricing basis should be monitored to ensure that it is appropriate for the risks being written

Question 247

The effects of closure to new business on expenses (6)

Answer 247

SHORT TERM EFFECTS
1. Most operations relating to the acquisition of business can be dispensed with immediately e.g., sales and marketing staff; new business systems
2. These expense reductions will be offset to some extent by additional costs associated with the closure including:
— redundancies
— disposal of marketing literature
— notifying policyholders
— early termination of office buildings’ leases.
3. Some product development and most systems development work can be stopped
4. The company might decide to cut back on its administration function, since quality service is no longer needed to attract new business.
LONG TERM EFFECTS
5. there will be further redundancies, as the number of staff required to administer a decreasing number of policies falls.
6. As the number of policies in-force decreases, fixed expenses will be split between an ever-decreasing number of policies. This effect will increase per-policy fixed expenses.

Question 248

The effects of closure to new business on the withdrawal rate (5)

Answer 248

SHORT TERM EFFECTS
1. Withdrawal rates may increase as a result of the bad publicity and concerns of policyholders regarding the security of their benefits.
2. Higher withdrawals will increase the rate at which the fund becomes too small to be practically managed as a separate entity.
3. If the company sold business through salespeople who now recommend products from other companies, the salespeople may encourage customers to transfer their existing policies to those other providers.
LONG TERM EFFECTS
4. Some of these withdrawals may be selective, leading to a worsening of the mortality and sickness experience of the company.
5. If service standards decline over time, withdrawals may increase.

Question 249

The effects of closure to new business on investment policy (8)

Answer 249

SHORT TERM EFFECTS
1. The loss of new business strain will have a positive impact on the SUPERVISORY SOLVENCY position, which might suggest a less constrained investment policy.
2. However, the policy is likely still to be very constrained given the poor solvency position.
LONG TERM EFFECTS
3. When the AVERAGE TERM outstanding becomes much shorter, the asset portfolio should be moved more towards shorter-dated, fixed-interest type investments to reduce the volatility of payouts.
4. This VOLATILITY will increase relative to the size of the fund as the size of the fund reduces.
5. The need for LIQUIDITY may increase as the fund runs off and if withdrawals increase. The company may be forced to dispose of illiquid assets at an unfavourable time. To prevent this, it could undertake a gradual move into more liquid assets
6. As the FUNDS UNDER MANAGEMENT decrease, the dealing costs will increase relative to the size of the fund, reducing net returns.
7. It will become harder to attract and retain good FUND MANAGERS and investment return might be negatively affected.
8. The TAX POSITION of the company may change as a result of contracting rather than expanding funds.

Question 250

The effects of closure to new business on a company’s with-profit bonus strategy (3)

Answer 250

SHORT TERM EFFECTS
1. Bonuses may have to be reduced to maintain the solvency of the company.
LONG TERM EFFECTS
2. The company may wish to use more deferral of distribution of surplus to provide some working capital to demonstrate solvency and as a cushion against adverse future experience.
3. The company should be conscious of policyholder expectations and the need to communicate with policyholders.

Question 251

Capital needs: Providers of financial services products (11)

Answer 251

Because everyone understands snacks I have gotten a food storage refrigerator
B- meet Benefits before premiums are received
E- meet development Expenses (new business strain e.g. commission; setting up management systems; inv & admin expenses)
U- hold a cushion against Unexpected events
S- meet Solvency/Statutory requirements
I- Invest more freely
H- High-risk investments
G- selling products with Guarantees
A- achieve strategic Aims
F- demonstrate Financial strength to attract business
S- Smooth reported profits
R- Risk appetite could determine it

Question 252

Possible reasons for basing a reinsurance company in an overseas country (6)

Answer 252

1. less conservative provisioning / reserving assumptions
2. less conservative solvency capital requirements
3. less onerous actuarial certification requirements
4. reduced income / capital gains and premium taxes
5. fewer investment restrictions
6. lower start-up capital requirements.

Question 253

How to improve a company’s regulatory capital position (12)

Answer 253

1. Funds could be MERGED - this could help if some of the regulatory requirements were calculated as a monetary or fixed amount per fund or were less onerous for funds above a certain size.
2. Assets could be changed - exchanging an inadmissible asset (that can’t be used to demonstrate regulatory solvency) for an ADMISSIBLE one
3. A switch in assets may change the VALUATION RATE of interest.
4. PROFITS could be RETAINED in the business - instead of distributing to shareholders / policyholders, it may be possible to defer the distribution of surplus
5. Reduce the level of NEW BUSINESS in the short term
6. REINSURANCE - Will reduce the volatility of claims and hence the required solvency capital
7. FINANCIAL REINSURANCE- reinsurer could provide a loan to the insurer, with the repayments contingent on a future profits of the reinsured block of business as such repayments may not need to be shown as a liability on a regulatory basis
8. The company could use DERIVATIVES to reduce market risk
9. Moving to LESS VOLATILE ASSET CLASSES, the company may be able to reduce the total level of assets needed to back the liabilities
10. Assets could be more CLOSELY MATCHED to the liabilities, reducing the need for a mismatching reserve
11. Reducing the level of guarantees under business sold
12. Selling unit-linked versions of contracts —> can be structured with high initial charges which reduce cap req

Capital management tools

Question 254

Capital needs: individuals (3)

Answer 254

1. Provide a cushion against unexpected events
2. Save for the future
3. Capital required to overcome timing differences of income & outgo

Question 255

3 pillars of Solvency II

Answer 255

1. Quantification of risk exposures and capital requirements
2. A supervisory regime and risk management
3. Disclosure requirements

Question 256

Basel accords: (3)

Answer 256

1. Capital requirements are assessed for each credit, market, and operational risks
2. These are aggregated without any allowance for diversification
3. Additional capital conservation and counter cyclical capital buffers must be held

Question 257

Advantages of internal models (4)

Answer 257

1. More sophisticated than factor-based capital requirements, stress tests & correlation matrices
2. Project company’s bal sheet for large number of future scenarios, which are intended to represent all the risks the company faces
3. Automatically allows for correlations between diff risk scenarios
4. Risk measures (VaR) used to determine the capital requirement

Question 258

Uses of internal models (6)

Answer 258

1. To calculate ECONOMIC CAPITAL using different risk measures, e.g. VaR and Tail VaR
2. To calculate CONFIDENCE LEVELS in the economic capital calculated
3. To apply different TIME HORIZONS to the assessment of solvency and risk
4. To include other risk classes not covered in the standard formula.
5. If you have a very DIFFERENT RISK PROFILE than the standard model highlights (does not have to be a massive company)
6. May be used to determine capital requirements under both Solvency II and Basel rather than using the standardised approach (this is subject to regulatory approval)

Question 259

How an insurance company could assess its economic capital requirement (6)

Answer 259

1. The economic capital requirement is the amount of capital that the company determines is appropriate to hold (in excess of liabilities) to cover its risks under adverse outcomes generally with a given degree of confidence and over a given time horizon
2. Typically, it will be determined based upon:
   * the risk profile of the individual assets and liabilities in its portfolio
   * the correlation of the risk
   * the desired level of overall credit deterioration that the company wishes to be able to withstand.
3. For each major risk type (e.g. credit, market, operational), a stochastic model or a deterministic model with scenario or stress testing will generally be used to determine the capital requirement.
4. A suitable stochastic model needs to produce INTERNALLY-CONSISTENT POSSIBLE FUTURE SCENARIOS,
   e.g. for market risk reflecting downturns in investment performance and inflation and their impacts on levels of withdrawals and new business.
5. The company would PROJECT ITS BALANCE SHEET for each of a large number of future scenarios, which are intended to represent all the risks the company faces.
6. A RISK MEASURE, e.g. VaR, would be used to determine the economic capital requirement

Question 260

How an insurance company could assess its Economic capital available (8)

Answer 260

1. The starting point for assessing the economic capital available is for the company to draw up an ECONOMIC BALANCE SHEET, which shows the market value of the company’s assets and the market value of its liabilities.
2. From this, the economic capital available would be determined as the excess of the market value of the assets over the market value of the liabilities.
3. For tradable assets, the market value of assets should be easily available.
4. It is possible that the portfolio may include some assets which are not tradable or for which a market value is not instantly available, and so an alternative valuation approach is needed.
5. In the unlikely event that any of its liabilities are tradable, the company could look up the MV of these liabilities
6. To calculate the MVL, For the majority of its liabilities it is likely to have to use an alternative approach, e.g. a replicating portfolio… use the market value of a portfolio of assets whose cashflows replicate the liability cashflows in all circumstances
7. The market value of liabilities can be determined using a discounted cashflow approach.
8. The company could determine the EXPECTED VALUE of the UNPAID LIABILITIES stated on a present value best estimate basis and add a risk margin
9. In addition to its current available economic capital, the company may also look at the availability in the market and the likely cost of various sources of further capital.

Question 261

The disadvantages of factor-based required capital calculations: (4)

Answer 261

CURL

C - to retain an appropriately stringent capital requirement in different conditions, the factors would need to be updated in the light of CHANGING CONDITIONS , e.g. changing asset values.
U - the factors may be chosen to be appropriate for a typical insurance company with typical risks - they are UNLIKELY TO BE SUITABLE FOR ALL COMPANIES
R - the simple calculation may not be appropriate to deal with some types of RISKS
L - the LARGE NUMBER OF FACTORS REQUIRED to capture all the risks that insurance companies may face

Question 262

How is a standard formula used to calculate the SCR? (3)

Answer 262

1. The SCR is determined through a combination of stress tests, scenarios and factor-based capital charges.
2. These allow for underwriting, market, credit default and operational risks.
3. The final SCR is determined from these individual component parts, using a correlation matrix to make allowance for any diversification benefits.

Question 263

Advantages of using the standard formula to calculate SCR (compared to using an internal model) (5)

Answer 263

1. Use of the standard formula has the advantage that the SCR calculation is less complex, time-consuming and resource-intensive to perform.
2. This may make the standard formula particularly attractive for SMALLER insurance companies.
3. Using the standard formula AVOIDS THE considerable WORK that is likely to be required in developing an internal model that meets the regulators’ requirements to be used in the SCR calculation.
4. The COST of doing this work may be greater than any benefit that would be achieved via a lower SCR.
5. Even if the company is developing an internal model for other purposes, e.g. to assess its economic capital position, there would be additional costs and uncertainty in seeking REGULATORY APPROVAL for its use in Solvency II.

Question 264

Disadvantages of using the standard formula for calculating the SCR (compared to using an internal model) (4)

Answer 264

1. As the calibration of the standard formula is based on an ‘average’ company the approximations it makes are NOT necessarily APPROPRIATE to all companies.
2. A company with a risk profile very different from the ‘average’ underlying the model may have a LOWER SCR if it calculated it using an INTERNAL MODEL that reflected its own business.
3. Companies with sophisticated risk management systems and controls may also benefit from a lower SCR calculated by an internal model that reflects these items more fully.
4. The company may be developing an internal model in any event, e.g. to assess its economic capital position. Using the internal model for Solvency lI would not therefore require the cost of developing a model ‘from scratch’ and would REDUCE INCONSISTENCIES between the regulatory capital and economic capital positions of the company.

Question 265

Similarities between regulatory and economic capital requirements (2)

Answer 265

1. Both relate to the ACCOUNT OF CAPITAL that needs to be held in order that future obligations are met.
2. An INTERNAL MODEL may be used for either calculation.

Question 266

Differences between regulatory and economic capital requirements (5)

Answer 266

1. The regulator may PRESCRIBED the assumptions and methodology to be used for the regulatory capital requirement calculations. The company will make its OWN DECISIONS on these aspects for its economic capital requirement calculations.
2. Method: Regulatory capital requirements may be determined using factor-based capital charges or a simple formula, whereas economic capital is more likely to be modelled.
3. Valuation basis: Regulatory capital requirements may be defined as the additional solvency capital amounts that need to be held in excess of the provisions as determined on the regulatory valuation basis, or as the sum of these additional capital amounts and any prudential margins in the liability valuation basis. Economic capital requirements are held in excess of the market consistent value of liabilities.
4. Regulatory capital requirements may be higher than economic capital requirements:
   a. regulator’s aim is to protect policyholders and so may require a company to hold more capital than would otherwise be considered to be necessary.
   b. Economic required capital may be lower than regulatory required capital due to a more sophisticated allowance for diversification benefits.
5. However, in some situations economic required capital may be higher, because the company:
   a. may take into consideration the need to hold capital for future strategic objectives that are not included in the regulator’s time horizon, including writing future new business
   b. is very risk averse (would want to hold more capital)
   c. uses a more stringent risk measure when determining economic capital (e.g. VaR) than is used for the regulatory capital requirement
   d. uses a standard formula / model to determine regulatory capital, but is riskier than the ‘average’ risk reflected in this formula / model
   e. may be targeting a high credit rating.

Question 267

Similarities between the Basel accord approach to with the Solvency II regime (4)

Answer 267

1. They both PRESCRIBED REGULATORY CAPITAL REQUIREMENTS that are held to cover unexpected losses.
2. STANDARDISED APPROACHES to determining minimum capital requirements are SPECIFIED BY THE REGULATOR in both cases, or alternatively an internal model may be used.
3. Solvency Il and Basel both have a THREE PILLAR STRUCTURE .
4. They are both INTERNATIONAL STANDARDS.

Question 268

Differences between the Basel accord approach to with the Solvency II regime (4)

Answer 268

1. Under the Solvency II SCR, capital must be held to meet a wide range of risks. Under Basel, capital must currently be held for the main risk categories: credit, market and operational.
2. Solvency II includes greater allowance for DIVERSIFICATION between risks than Basel.
3. Solvency II capital requirements may be more COMPLEX to model, even under the standard formula, e.g. needing the use of stochastic models.
4. Under Basel, banks must hold extra buffers: capital conservation and countercyclical capital.

Question 269

Additional reports accompanying accounts (6)

Answer 269

CIRCUS

Chairperson’s / CEO’s statements
Investment report
Remuneration report
Corporate governance report
Uncertainty (risk) report
Strategic report

Question 270

Information to be disclosed to benefit scheme members (6)

Answer 270

SCRIBE

Strategy for investment
Contribution obligations
Risks involved
Insolvency entitlement
Benefit entitlements
Expense charges

Question 271

Common aims of accounting standards (in relation to benefit scheme disclosures) (4)

Answer 271

CARD

C- Consistency in accounting treatment from year to year
A- Avoiding distortions resulting from contribution fluctuations
R- Recognising the realistic costs of accruing benefits
D- Disclosure of appropriate information

Question 272

Reasons why disclosure is important in a benefit scheme (7)

Answer 272

SIMMERS

Sponsor is aware of financial significance of benefits
Informed decisions can be made
Mis-selling is avoided
Manages the expectations of members
Encourages take up
Regulatory requirement
Security of scheme improved as sponsor / trustees are made more accountable

Question 273

Reasons for analysing surplus (12)

Answer 273

DIVERGENCE

D- financial effect of Divergence of actual experience vs expected (valuation assumptions)
— determine the assumptions that are the most financially significant (the main contributor of any surplus)
I- Information to management and for publication in the providers accounts
V- demonstrate that the Variance in the financial effect of the individual sources is a complete description of the variance in the total financial effect
E- Experience monitoring to feedback into ACC to adjust the expected experience (a means of assessing or noticing trends)
R- Reconcile values for successive years
G- Group into non-recurring/ recurring sources of surplus to help make decisions about distributing surplus
E- provide data for use in Executive remuneration schemes
N- shows financial effects of writing New business (new business strain)
C- Check (validate) assumptions and calculations used
E- Extra check on valuation data and process, if carried out independently

Question 274

Sources of Surplus (17)

Answer 274

Divergence from valuation assumptions of:
CLAIMS:
1. Mortality/longevity
2. Morbidity
3. Claim frequency
4. Claim amounts
VOLUME:
5. New business levels
— proportion of policyholders who renew
6. Withdrawal / lapses
OTHER CASHFLOWS:
7. Investment income and gains
8. Expenses
9. CommissIon
10. Premiums / contributions paid
ECONOMIC FACTORS:
11. Salary growth
12. Inflation
— expense inflation
— claim inflation
13. Taxation
STRATEGIC EVENTS:
14. Failure of counterparty
15. Business/fund restructure => bulk sales, acquisitions
16. Change to valuation method or assumptions
17. Once off events

Question 275

Levers on Surplus/Profit (7)

Answer 275

1. Reduce likelihood of claims:
   - Good underwriting at proposal/entry
   - Good underwriting at claim stage (Steve said he doesn’t like this)
   - incentive NOT to claim (excess, no claims discount)
2. Reduce the cost of claims:
   - Cost-effective claims management procedures (by periodically reviewing ongoing claims, proof of eligibility of disability for a disability benefit)
   - Reinsurance
   - Reducing future benefits
   - Keeping guaranteed benefits to a minimum
   - Increase excesses
3. Control expenses:
   - Expense review
   - Keep charges/premiums flexible
   - Ensure claims expenses commensurate claims size (Eg: Car accident, below no. just pay, above -> more investigations)
4. Increase renewals and/or reduce lapses
   - automatic renewal
   - renewal notices
   - good customer service
   - allow for missed payments
   - change distribution strategy
5. Follow an investment policy that increases investment returns (subject to an acceptable level of risk)
6. Adopt an effective tax management policy.
7. Increase profitability
   — increase premiums
   — make premium more marketable
   — cheaper sales channels

Question 276

Methods to increase renewal rates (9)

Answer 276

1. Automatic renewal
2. Issue of renewal notices
3. Loyalty discounts
4. Good customer service
5. Marketing activities
6. Competitive premiums
7. Allow for missed payments
8. Change distribution strategy
9. Redesign products

Question 277

Factors affecting withdrawals: (4)

Answer 277

1. Ability to pay
2. Competitive rates
3. Need for money in investment policy
4. Poor customer service

Question 278

Factors that will affect the amount of surplus distributed in a life insurance company (11)

Answer 278

1. PERFORMANCE of the product (surplus arising) over the year
2. SMOOTH experience over time- holding back money in good years, so that it does not need to reduce discretionary benefits in bad years.
3. Regular bonuses may be held back to pay for terminal bonuses
4. Provision of capital- company may wish to defer the distribution of bonuses to increase the companies free assets which will increase investment freedom and to finance a new business
5. Margins for future adverse experience- if experience is much worse than anticipated margins for profit may be used to compensate the company (retain margin against uncertainty)
6. Company objectives
   - trade off between 5 and 6. If the objective is to expand the business, the company would reduce margins to increase free assets. If the objective is to maximise profit distribution to policyholders to improve competitive position, the company would limit its free assets and ability to survive risk events
7. Policyholders reasonable expectations
   • for with-profit policies it would be used to increase benefits
   • for without- profit policies it would be used to improve policyholder benefit security, service levels
   — Marketing literature
   — past performance
   — consistency with other with-profit products
   —current industry practice
8. Policyholders, shareholders (expect dividends or the retention of profits to lead to more profit) and other stakeholders expectations (staff may expect bonuses)
9. Regulatory restrictions
10. Consider current capital position. Can be used as working capital
11. Consider current solvency position. - whether it needs to rather retain/distribute profits in order to increase/decrease the solvency

Question 279

Factors that will affect the decision about the application of surplus in a benefit scheme (8)

Answer 279

1. LEGISLATION
   — May require that surplus be used to increase the benefits instead of reducing future contributions
   — Dictate which categories of members should have priority
   — May dictate the permissible form of a contribution reduction
2. TAXATION
   — Surplus funds may be excluded from beneficial treatment
   — Likely that the sponsor would be required to pay tax if receiving a return of surplus funds (if not, the system would be open to manipulation for tax-avoidance)
3. SCHEME RULES
   — Sponsor chose to place restrictions in the scheme rules on the use of surplus funds… to prevent disputes if surplus arose
4. DISCRETION OF THE SPONSOR
   — If there’s no detailed restrictions, the sponsor or trustees or scheme manager may be given the right to choose how to apply the surplus
5. RISK EXPOSURES
   — Consider risk exposure of the various parties e.g. if the sponsor must take on a deficit, they should take on a surplus?
   — Security of the members benefit entitlement is of vital importance e.g. if the sponsor is having CF problems
6. SOURCES OF SURPLUS
   — Extra contributions in excess of what was strictly required from the sponsor
   — Whether or not members contribute to the scheme
   — Volatile assets that performed well
7. SPEED OF CORRECTIVE ACTION
8. INDUSTRIAL RELATIONS

Question 280

The main purposes for which a general insurance company monitors claims data (10)

Answer 280

1. reviewing premium rates and setting rates for new or amended products
2. estimating the cost of outstanding claims to set provisions
3. comparing actual claims run off against previous estimates
4. providing management information
5. analysing the sources of surplus
6. assessing the relative profitability of different blocks of business
7. monitoring the adequacy and use of reinsurance
8. monitoring the company’s solvency position
9. assessing and improving the underwriting and claims management processes
10. financial planning

Question 281

The main purposes for which a general insurance company monitors expenses (7)

Answer 281

1. measure the past performance (PROFITABILITY ) of each insurance class
2. determine the expenses loadings for PREMIUM RATING
3. determine the expenses loadings for PROVISIONING
4. SPOT ANY INEFFICIENT AREAS of the business in order to implement cost-cutting exercises
5. conduct a FINANCIAL PLANNING exercise (expense budgeting)
6. analyse its sources of SURPLUS
7. manage its CASHFLOW POSITION, in order to ensure that liquid funds are available to pay the expenses

Question 282

Possible reasons for these high rates of lapse and surrender (12)

Answer 282

INAPPROPRIATE SELLING
1. policies may have been sold very aggressively.
2. the company might have paid higher than market rates of commission to encourage sales
3. the products might have been very heavily marketed, perhaps including special introductory offers to entice sales
4. inappropriate or inadequate selling procedures may have been used
5. policies being sold that do not meet the customers’ needs.
PRODUCT TERMS AND COMPETITION
6. Policyholders may find the same product elsewhere for a cheaper premium
7. company has increased its premium or charges recently
8. Intermediaries may persuade policyholders to switch
POOR PERFORMANCE
9. Poor investment performance
10. poor customer service - admin delays, poor systems

11. Surrender values under the new savings policies are higher than those of competitors
12. Unfavourable media coverage

From Sasha… economic downturn?

Question 283

Actions that can be taken to improve the withdrawl rate (8)

Answer 283

1. analyse the withdrawal experience in order to identify the exact reasons for the poor experience.
2. Carry out surveys in order to identify better the reasons
3. increasing the quality of customer service
   — Improve the companies administrative capability
   — Spend more of its resources in developing its investment capability
4. ensure that future sales meet customer needs
   — Product design a need to be altered
5. provide suitable training to salespeople as to how the policy should be sold and to whom
6. Compare premium rates to competitors and adjust where needed
7. Provide a disincentive to withdraw e.g., increasing surrender penalties
8. Improve brand image

Question 284

How would a life insurance company analyse its claims experience (9)

Answer 284

1. In order to determine actual claims experience, the number of claims experienced is divided by the matching number of policies exposed to risk.
2. The data should be split into HOMOGENEOUS groups while keeping the volume of data within each group credible.
3. The extent to which this is feasible will depend on the volume of business written
4. Ideally, the analysis would be broken down by year of claim. It may be necessary to group the experience for some older calendar years together
5. Only business accepted at standard rates should be included.
6. The most important levels at which to carry out the investigation are:
   * Gender
   * Age
   * smoker status
   * duration since outset (grouped for longer durations) - experience will be lighter at early durations due to underwriting
   * sales channel (this is an indicator of target market).
7. If enough data exists then the investigation could also be split by:
   * type of illness
   * medical / non-medical cases
   * occupation
   * premium size
   * premium payment method.
8. Claims experience should be analysed both net and gross of reinsurance.
9. The company will then compare the actual claim rates experience with those assumed in the pricing when the contract was designed

Question 285

Why results may not be indicative of future experience (4)

Answer 285

1. CREDIBILITY- The main limitation is the volume of data used in the analysis
2. Changes over time
   — Underrating standards
   — Sales process / distribution channel
   — target market
   — average premium size
   — medical advances
3. Historical data may have included ABNORMAL EVENTS which are not expected to recur in the future
4. There will always be RANDOM VARIATION

Issues with past data and data risks

Question 286

Reasons for monitoring experience (5)

Answer 286

1. Update the method and assumptions so that they are more relevant to future experience
2. Monitor any trends and experience particularly adverse trends, so as to take corrective actions
3. Provide management information
   — Risk management
   — Financial planning
   — Manage cash flow position
4. Reporting
   — management information
   — regulatory information
5. Analyse source of surplus

Question 287

Data required for monitoring (3)

Answer 287

1. Reasonable VOLUME of stable consistent data from which future experience and trends can be deduced
2. Data ideally needs to be divided into sufficiently HOMOGENEOUS risk groups
3. Data on the exposure to risk divided into the same cell structure as the experience data

Question 288

Before using the monitoring data (3)

Answer 288

1. Consideration should be given to whether the period under investigation was TYPICAL and whether the experience is likely to be representative of the future experience
2. Allowance should be made for:
   — trends
   — cycles
   — abnormal events
   — random fluctuations
3. Before being used as assumptions the result of experience analysis should be adjusted to allow for data and modelling risk

Question 289

Role of banks (4)

Answer 289

1. Provides liquidity to individuals, institutions, and firms (lends money)
2. Act as financial intermediaries
   - Brings together providers and users of capital
   - Provides means which funds can be transferred from depositor to borrower
3. Distribution of valuable economic and business info
4. Act as a worldwide barometer of economic health and business trends

Question 290

Types of banks (5)

Answer 290

1. Traditional deposit-taking banks/ commercial banks/ retail banks
2. Development banks/ Development Financial Institutions (DFI) - provide credit through high risk loans to both public and private sector initiatives
3. Reserve/central Banks
4. Investment banks
5. Community banks - membership based, decentralised and self-help financial institutions

Question 291

What risks does the bank take if it funds long-term loans with short-term deposits (2)

Answer 291

1. The risk is that interest rates will rise, so that, when deposits are renewed, the bank has to pay a higher rate of interest. The rate received on loans will not change. The result will be a reduction in the bank’s net interest margin.
2. Liquidity risk if many customers withdraw their money at the same time. The bank will not have funds available to process those withdrawals. This event is known as a bank run.

Question 292

Why corporate bonds have higher yields than government bonds (4)

Answer 292

1. Security
   — in general, corporate bonds are less secure than government bonds.
   — degree of security offered by government bonds will vary between different governments. Politically stable? Developed?
   — degree of security offered by a corporate bond will depend on the issuing company and its industry, credit rating
2. Marketability
   Depends on:
   — issuer of debt
   — size of the issue (size of issue is usually smaller compared to government bonds. With government bonds, investors can deal in large quantities with little or no impact on price)
   — frequency of trading
3. Volatility
   —The yield on a fixed-interest bond is a function of price, which will be determined by supply and demand, and will hence be affected by investor sentiment.
4. Tax
   — if government bonds have preferential tax treatment, then a higher yield might be required on corporate bonds to compensate investors for holding them.
5. Liquidity

State the obvious: investors will require a higher yield to compensate for …

Question 293

How economic factors can influence the investment market for property (6)

Answer 293

the investment market for property by altering:
— either the demand for, or supply of properties for sale on the market.
— the level of rents in the occupancy market.

1. higher inflation and higher economic activity will increase rents, hence increase the capital values of property.
2. An increase in REAL INTEREST RATES should increase the rate of return required by investors, leading to a lower present value of a given stream of rents.
3. Increasing UNCERTAINTY about INFLATION may increase demand for property investment (a real asset) as a hedge against inflation.
4. An expectation of a long-term strengthening of the DOMESTIC CURRENCY might encourage demand from overseas investors.
5. Strong (INSTITUTIONAL ) CASHFLOWS, i.e. into life offices and pension funds, could increase these institutions’ demand for property.
6. The RELATIVE ATTRACTIVENESS of other ASSET CLASSES will also affect the demand for property.

Question 294

The economic factors that affect the level of conventional government bond yields (6)

Answer 294

1. Inflation expectations- Inflation erodes the real value of income and capital payments and so expectations of a higher rate of inflation are likely to lead to higher nominal bond yields.
2. Inflation uncertainty- the higher the uncertainty, the higher the inflation risk premium.
   Required return=Required risk-free rate of return + Expected inflation + Risk premium
3. Short-term interest rates-
   - The yields on short-term bonds are closely related to returns on money market instruments, so a reduction in short-term interest rates will mean a reduction in short-term bond yields.
   - However, investors in long bonds may interpret a cut in interest rates as a sign of quantitative easing, that will increase inflation over the longer term
   - … so the yield on long bonds might decline by a smaller amount, or even rise relative to the yield on short bonds.
4. Fiscal deficit- If the government’s fiscal deficit is funded by borrowing, then the resulting supply of bonds is likely to put upward pressure on bond yields …… especially at the durations in which the government is concentrating most of its funding.
5. Exchange rate
6. Institutional cashflow -If institutions have an inflow of funds because of increased levels of savings, there will be increased demand for bonds of their desired term. The yield on such bonds will fall.

Question 295

How can the government respond if inflation rates are increasing? (2)

Answer 295

1. Tighten monetary policy by:
   a. raising short-term interest rates (by a sufficient amount to increase real short-term interest rates).
   — higher interest rates mean higher borrowing costs, people will eventually start spending less. The demand for goods and services will then drop, which will cause inflation to fall.
   b. selling Treasury bills to reduce the money supply or unwinding quantitative easing.
2. Fiscal policy may also be tightened (I.e. government expenditure reduced and/or taxes raised).

Question 296

Three policy objectives and the government may try to achieve by altering the level of short-term interest rates (3)

Answer 296

1. INCREASING THE LEVEL OF ECONOMIC GROWTH
   … by reducing interest rates.
   This reduces the cost of borrowing …
   … and hence encourages investment spending by firms…
   … and increases the level of consumer spending.
   This leads to an increase in demand for goods and services, and economic growth.
2. REDUCING INFLATION
   … by increasing interest rates.
   This reduces the quantity of money demanded, which in turn can lead to a reduction in the quantity
   of money supplied.
   This can reduce inflation, by the quantity theory of money.
   High interest rates can also reduce aggregate demand, and demand pull inflation.
3. DEVALUING THE DOMESTIC CURRENCY
   … by reducing interest rates.
   If interest rates in one country are low relative to other countries, international investors will be less inclined to deposit money in that country.
   This decreases demand for the domestic currency and tends to decrease the exchange rate.
   This reduces the price (in other currencies) of exports which may lead to an increase in economic growth
   This increases the price (in the domestic currency) of imports which may need to cost push inflation

Question 297

Demand for an asset will change if:

Answer 297

1. investors perceptions of the characteristics of the asset, principally risk and expected return, alter
2. investors’ opinions of the properties of the asset remain unchanged but external
   factors alter the demand for that asset. These external factors include:
   • Investors’ cashflows
   • Investors’ preferences
   • The price of other assets

Investors’ preferences are influenced by:
• a change in their liabilities
• a change in the regulatory or tax regimes
• uncertainty in the political climate
• ‘fashion’ or sentiment altering, sometimes for no discernible reason
• marketing
• investor education undertaken by the suppliers of a particular asset class
• sometimes for no discernible reason.

Question 298

Steps of scenario analysis (5)

Answer 298

1. Grouping of risks into broad categories
2. Development of a plausible adverse scenario
3. For each scenario the organisation must translate the scenario into assumptions for the various risk factors in the model
4. Calculation of the consequences of the risk event occurring for each scenario
5. Total costs calculated are taken as the financial cost of all risks represented by the chosen scenario

Question 299

Types of stress scenario tests (2)

Answer 299

1. to identify ‘weak areas’ in the portfolio and investigate the effects of localised stress situations by looking at the effect of different combinations of correlations and volatilities
2. to gauge the impact of major market turmoil affecting all model parameters, while ensuring consistency between correlations while they are ‘stressed’.

Question 300

A stochastic model is often limited by one of following approaches (3)

Answer 300

1. Restrict the duration (or time horizon) of the model
2. Limit the number of variables modelled stochastically and use a deterministic approach for the other variables.
3. Carry out a number of runs with a different single stochastic variable and then a single deterministic run using all the worst case scenarios together.

Question 301

The advantages of the notional approach (1)

Answer 301

Simple to implement and interpret across a diverse range of organisations.

Question 302

The disadvantages of the notional approach (5)

Answer 302

1. Potential undesirable use of a ‘catch all’ weighting, for (possibly heterogeneous) undefined asset classes
2. possible distortions to the market caused by increased demand for asset classes with high weightings
3. treating short positions as if they were the exact opposite of the equivalent long position (in practice, they might affect the capital requirements to different extents)
4. no allowance for concentration risk, as the risk weighting for an asset class is the same irrespective of whether the investment in that asset class consists of a single security or a variety of different securities
5. the probability of the changes considered (in the values of assets and/or liabilities) is not quantified.

Question 303

The advantages of the factor sensitivity approach (1)

Answer 303

Factor sensitivity approach determines the degree to which an organisations financial position is affected by the impact that a change in a single underlying risk factor has on the value of assets and liabilities
1. increased understanding of the drivers of risk.

Question 304

The disadvantages of the factor sensitivity approach (3)

Answer 304

Factor sensitivity approach determines the degree to which an organisations financial position is affected by the impact that a change in a single underlying risk factor has on the value of assets and liabilities
E.g. increase of 20% withdrawal risk
1. not assessing a wider range of risks, by focusing upon a single risk factor
2. being difficult to aggregate over different risk factors
3. the probability of the changes considered (in the values of assets and/or liabilities) is not quantified

Question 305

Advantages of VaR (5)

Answer 305

VaR- the maximum potential loss on a portfolio over a given period with a given degree of confidence
1. the simplicity of its expression
2. the intelligibility of its units, i.e. money
3. its applicability to all types of risks
4. its applicability over all sources of risk - facilitating easy comparisons between products…
… and across businesses
…its inherent allowance for the way in which different risks interact to cause losses
5. the ease of its translation into a risk benchmark, e.g. risk limit.

Question 306

Disadvantages of VaR (5)

Answer 306

1. It gives no indication of the distribution of losses greater than the VaR,…
   … e.g. does not reveal how much is likely to be lost should a loss occur that is greater than the VaR
2. It can under-estimate asymmetric and fat-tail risks as it does not quantify the size of the ‘tail’
3. it can be very sensitive to the choices of data, parameters (e.g. confidence level, time horizon) and assumptions
4. VaR is not always sub-additive (Subadditivity means that a merger of risk situations does not increase the overall level of risk.)
5. if used in regulation it may encourage herding’,…
   … thereby increasing systemic risk.

Question 307

How do regulators correct perceive market inefficiencies and to promote efficient and orderly markets in practice (4)

Answer 307

1. Ensuring sufficient liquidity in the market place, e.g. by having market makers
2. The provision of settlement systems (to ensure that trades are carried out in an efficient and orderly way)
3. Imposing stock exchange requirements on listed companies
4. Ensure that investors have adequate information so that they can trade confidently and fairly

Question 308

How would a general insurance company selling healthcare products analyse a claims experience (7)

Answer 308

1. Split the data into HOMOGENEOUS groups, whilst keeping the volume of data within each group credible.
2. Likely GROUPINGS of data include
   - Sex
   - Age (grouped as required)
   - Plan selected
   - Occupation
   - Smoker Status
   - Duration since joining scheme (Experience may be lighter at early durations due to underwriting)
   - Sales Channel
   - Type of claim/illness/expense
   - Elective vs. non-elective procedures.
   - Underwriting year
3. The investigation will likely consider the FREQUENCY of certain types of claims.
   as well as the SEVERITY of such claims
   — it will also include the premiums earned associated with the exposure.
4. The analysis would be performed to cover the EXPERIENCE FOR EACH YEAR in the investigation, to…
   … include TRENDS over time
5. The experience is CALCULATED as the claims divided by the exposed to risk.
   — It is critical that the claim data and the exposed to risk data correspond..
   so care needs to be taken to assign claims to the date of event/claim/procedure,
   and not the date of notification and date of claim settlement.
6. Measurement of DELAYS between event and settlement may prove useful
7. The exposed to risk will normally be the average of the in-force policies at the year start and the year-end.
   but given computing power this may even be done on more accurate level e.g. monthly.
   - in places data may need to be grouped together for credibility.
   - It would be important to take into account any benefit definition or limit changes over time.
   as well as adjust amounts for INFLATION where appropriate

Claims may include amounts claimed for, as well as actual amounts paid.
both on an amount and count basis
- Declined claims may be included as well if useful.
- In more recent vears allowance would need to be made for IBNR claims.
- Persistency can also be analysed with this data set by tracking % of policyholders that stay on risk each year.

Question 309

Steps in the ACC (5)

Answer 309

1. General commercial and economic environment
2. Specify the problem
3. Developing the solution
4. Monitoring the experience
5. Professionalism

Question 310

ACC: General commercial and economic environment (8)

Answer 310

The company should investigate
1. the COMPETITION ,
2. the current stage in the UNDERWRITING CYCLE
3. any TRENDS in this market sector such as demand for insurance
4. the nature of the claim risks
5. the size of the claims
6. The needs of SHAREHOLDERS must be identified, and their interests understood
7. The needs of POLICYHOLDERS must be identified, and their interests understood
8. The ECONOMIC outlook

Question 311

ACC: Professionalism (6)

Answer 311

1. Ensure that any relevant guidance is adhered to.
2. Communications (verbal and written) must be clear
3. Ensure that TCF principles are adhered to
4. Actuary to adhere at all times to professional contact standards
5. Imperative for the entry to thoroughly understand any assumptions that are made
6. Likely that the actuary would engage with the lawyers and underwriters and have respect for the opinions of others

Question 312

External environment factors (16)

Answer 312

CREATE GRAND LISTS
Corporate structure
Regulation and legislation
Environmental issues and climate change
Accounting standards
Tax
Economic outlook (eg interest rates, inflation, growth and exchange rates)

Governance
Risk management requirements
Adequacy of capital and solvency
New business environment
Demographic trends

Lifestyle considerations
International practice
State benefits
Technology
Social and cultural trends

Question 313

Functions of the central bank (5)

Answer 313

1. Control the money supply
2. Determine or influence
   — interest rates
   — inflation rates
   — exchange rates
3. Target economic features such as growth and unemployment
4. Ensure stability of the financial system
5. Be the lender of last resort to commercial banks

Question 314

Prescriptive rules that may be imposed (Regulation) (7)

Answer 314

1. Types of investments or contract offered
2. Types of services provided
3. Charges or premiums that may be levied
4. Types of investment that may be included
5. Types of investments which the financial institution may itself invest (e.g., crypto)
6. Required levels of capital adequacy
7. Who make control the institution or advise on products

Question 315

Types of advice (3)

Answer 315

1. Factual advice - Based on research of facts such as legislation
2. Indicative advice- Giving an opinion without fully investigating the issue
3. Recommendations- Researched and modelled forecasts with alternatives considered and weighed up against each other

Question 316

Advantages of discounted dividend model (4)

Answer 316

1. Reflects the value of the assets if held over the long term
2. Easily consistent with value of liabilities
3. Can take account of expenses (net discount rate)
4. Can adjust discount rate to allow for level of riskiness

Question 317

Disadvantages of discounted dividend model (4)

Answer 317

1. Requires assumptions for discount rates and income projected far into the future
2. In the case of bond projecting income it will be quite simple but in the case of equities, assumptions will be needed for dividend growth
3. Will involve judgement and may incorporate bias
4. Different actuaries would place different values on the assets

Question 318

Methods of valuing assets (8)

Answer 318

1. Historic book value
2. Written up or down book value
3. Market value
4. Smoothed market value
5. Fair value
6. Stochastic model
7. Discounted cashflow model
8. Arbitrage value

Question 319

Advantages of flexible benefit systems to employees (4)

Answer 319

1. Allows employees to select from a menu of options
2. Different groups within the workforce can select benefits appropriate to them
3. Benefit packages can change over time as personal circumstances change
4. Can meet their personal financial or non-financial goals

Question 320

Advantages of flexible benefit systems to employers (6)

Answer 320

1. Aids recruitment + retention of quality staff
2. Rewards package can be made attractive to different groups
3. Improves employee satisfaction
4. Gives benefits to staff in a cost-effective manner ( benefits they want)
5. Introducing benefits can be done at little to no cost
6. Annual enrollment in the scheme reminds employees of the value of their benefits which increases employee appreciation

Question 321

Disadvantages of flexible benefit systems to employees (2)

Answer 321

1. May prioritise benefits incorrectly
2. So many options can be overwhelming

Question 322

Disadvantages of flexible benefit systems to employers (2)

Answer 322

1. More admin
2. May need to appoint a benefits advisor

Question 323

Advantages of eliminating state provision and implementing compulsory saving in the private sector (10)

Answer 323

1. Results in an increased level of pension provision
2. … and reduction in the level of poverty in retirement
3. Coverage is universal
4. Reduces reliance on state benefits
5. Can work in practice
6. Private provision may be more competitive —> lower costs
7. May generate a demand for investments —> stimulate the financial market
   FOR THE GOVERNMENT
8. Frees up funds to target other causes
9. Not necessary to offer incentives
10. Reduction in taxes

Question 324

The difference between a forward and a future

Answer 324

FUTURE:
1. Standardised (All details surrounding asset traded except for the price are predetermined) and exchange traded (transparent and based on supply and demand)
2. Require a deposit or margin upfront to act as collateral to cover risk of default
3. Institutional guarantee provided by the clearinghouse
4. Contracts are marked to market daily —>daily changes are settled day by day until the end of the contract
5. Market is highly liquid
6. Usually close out prior to maturity (cash settlement takes place)

FORWARD
1. Non-standardised and over-the-counter (negotiated between two parties and have less regulatory oversight)
2. High degree of credit risk since they are private agreements
3. No upfront payment
4. Negotiations would be required to close out a forward

Question 325

Key differences between futures and option contract (5)

Answer 325

FUTURE
1. Obligation to buy or sell
2. Exchange tradable
3. Standardised
4. No premium paid by buyer or seller
5. Margin paid to clearing house by both parties

OPTIONS
1. Right not obligation to buy or sell
2. Exchange tradable or over-the-counter traded
3. Standardised or non-standardised
4. Premium paid from holder to writer
5. Margin paid to clearing house by writer only (exchange tradable only)
—> Only the writer of an option has an obligation to trade if the holder exercise their right to trade
— therefore, they pose a credit risk
— margin is only required from the writer of an option

Question 326

Key requirements relating to the design of the proposal form to ensure good quality data is achieved (10)

Answer 326

1. The proposal form needs to be designed to collect data at an appropriate level,
   … including data that although not used currently may be needed in the future
2. Proposal form must be CLEAR and UNAMBIGUOUS , so the proposer gives correct information
3. It should have inputs that are QUANTITATIVE as far as possible. Input of data onto the system
4. The system should have inputs in the same order as the proposal form
5. and ensure that the data capturer does not need to interpret the information.
6. Data capturers inputting the information should be well trained.
7. Where input fields can be inferred from other data, the system should pre-populate them
(e.g. date of birth and gender can both be inferred from the ID number)
8. Financial incentives could perhaps be offered for accuracy of input.
9. The data system should have VALIDATION CHECKS…
   - checks on blank entry fields
   - sensible entry values
10. The insurer may send the policyholder a copy of the key information. and ask them to VERIFY that it is correct

Not in the notes but questions should be objective

Question 327

Characteristics of critical illnesses (3)

Answer 327

1. A condition perceived by the public to be serious and to occur frequently
2. Each condition covered can be DEFINED CLEARLY so that there is no ambiguity at the time of claim
3. There is sufficient DATA to price the benefit

Question 328

How to price a healthcare benefit/considerations (8)

Answer 328

1. Demographics on the target population e.g., age; sex
2. Utilisation info e.g., propensity for hospital benefit admission; GP visit utilisation
   — existing claims data set can be used as a basis for the utilisation assumption
   — could risk adjust the existing claims data set to estimate the expected utilisation
3. Tariff assumptions e.g., remuneration rate for a GP visit
   — adjust existing dataset if tarring rates differ
   — May be negotiated rates
4. CPI Assumption to adjust the claims and expenses
5. Consider admin and other expenses
   — Determent off the cast with other in-force books
   — Could be set as a percentage of premium
6. Profit margin requirements?
7. Group discounts offered?
8. Compare final costing to the adjusted norm
   — competitor analysis

Question 329

Features of a corporate bond issue that would reduce risk (13)

Answer 329

REDUCE PROBABILITY OF DEFAULT
1. Type of debt- high-ranking debt like the debentures (rather than lower ranking debt like unsecured debt or subordinated debt)
2. The existence of fixed or floating charges
3. High levels of income/capital cover
4. Restrictions on further corporate borrowing
5. A lack of prior ranking debt
6. Parent company guarantee is being in place whether loan has been issued by a subsidiary
7. Third-party guarantees
8. Registering any security and ensuring that the investor can enforce that security on default
9. a shorter term issue
INCREASE MARKETABILITY
1. A large issue size
2. no options set against the investor e.g., option for early redemption
3. options for the investor e.g., convertible debt
4. a stock exchange listing

Question 330

Methods of aggregating capital requirements across individual risks in order to determine the overall capital requirement:
Advantages of summing the individual capital requirements (3)

Answer 330

1. it is very simple and quick to apply.
2. No assumptions are needed.
3. It is appropriate if risks are fully dependent.

Question 331

Methods of aggregating capital requirements across individual risks in order to determine the overall capital requirement:
Disadvantages of summing the individual capital requirements (3)

Answer 331

1. Risks are normally only partially dependent (or independent).
2. This approach will therefore overstate capital requirements.
3. This will result in inefficient use of capital, opportunity cost and increased cost of capital.

Question 332

Methods of aggregating capital requirements across individual risks in order to determine the overall capital requirement:
Advantages of using a correlation matrix (3)

Answer 332

1. It is simple to apply.
2. It’s a common technique that is well understood.
3. It allows for partial dependency between risks.

Question 333

Methods of aggregating capital requirements across individual risks in order to determine the overall capital requirement:
Disadvantages of using a correlation matrix (4)

Answer 333

1. Populating the matrix requires subjective assessment.
2. There are underlying assumptions that may not hold in practice, …
3. … e.g. that correlation factors between risks do not vary under different conditions.
4. In particular, correlations may change during extreme market events.

Question 334

Methods of aggregating capital requirements across individual risks in order to determine the overall capital requirement:
Advantages of using stochastic modelling (3)

Answer 334

1. It can allow for partial dependency between risks.
2. It provides a distribution of outcomes.
3. It allows automatically for programmed correlations between events under each simulation, and these can vary according to the simulated conditions.

Question 335

Methods of aggregating capital requirements across individual risks in order to determine the overall capital requirement:
Disadvantages of using stochastic modelling

Answer 335

1. It can be impractical due to the long run-time required.
2. It requires expertise and resource to build the model.
3. Calibration and programming of the correlation rules can be particularly complex.

Question 336

Methods of aggregating capital requirements across individual risks in order to determine the overall capital requirement:
Advantages of using a copula (4)

Answer 336

1. It allows for partial dependency between risks.
2. Different forums of copula are available to suit different degrees of dependence.
3. It is a sophisticated way of allowing for dependence in the tails of distributions.
4. It therefore helps with minimising tail risk and optimising portfolios.

Question 337

Methods of aggregating capital requirements across individual risks in order to determine the overall capital requirement:
Disadvantages of using a copula (3)

Answer 337

1. Expertise is required, as it can be mathematically complex.
2. The choice of copula and its calibration (or parameterisation) can be difficult.
3. It can be difficult to explain to end users of the outputs.

Question 338

Issues to consider when reporting on risk (5)

Answer 338

1. The company needs to consider whether the RUIN PROBABILITY should be expressed over a single year or over the whole run-off of the business. In the latter case the ruin probability will be a much higher figure than in the former.
2. The company needs to decide how to assess the CORRELATION between the risks. The most common technique uses a correlation matrix. Populating the correlation matrix is a largely subjective exercise.
3. The company needs to decide how to take account of the INTERACTIONS between risks, since these interactions may mean than the effect of multiple risk events is greater or less than the sum of the individual risks. A practical technique needs to be developed to address this.
4. The company needs to decide how to deal with RISKS which are HIGHLY SUBJECTIVE(e.g. operational risks), particularly when it is necessary to construct a plausible adverse scenario that occurs at a very low probability. It is tempting to think of risk events that have occurred, which are therefore likely to be more common than the required ruin probability.
5. Using PAST DATA to ESTIMATE FUTURE CONSEQUENCES of rare events needs to be undertaken with caution, since the past may not prove to be a good guide to the future.

Question 339

How to determine an appropriate risk discount rate for a project appraisal (7)

Answer 339

1. Choose between a NOMINAL vs REAL discount rate
   — should be consistent with cashflows (use nominal if cashflows are nominal)
2. If the project has HIGH LEVEL of SPECIFIC /DIVERSIFIABLE RISK, do a specific risk analysis
   using scenario analysis and stochastic modelling
3. For NORMAL LEVELS of SYSTEMATIC RISK:
   a. Start from current cost of raising incremental capital
   b. Use weighted average cost of capital..
   .. taking tax effects into account
   c. Cost of debt is cost in real terms of new borrowings
   d. Cost of equity capital is current expected real return on index-linked bonds
   … plus margin to allow for additional return required by equity investors to compensate for extra risk
4. Use a higher discount rate when evaluating projects with higher than usual systematic risk
5. Common to use very high discount rates to appraise proposed projects.
   .. particularly those that involve entering new markets
6. Too high a rate distorts the balance between short-term and long-term cashflows
   .. which leads to poor decision-making
7. Too much precision in selecting the risk discount rate is unnecessary
   … as NPV calculations are not very sensitive to small changes in the discount rate

Question 340

Disadvantages of a deterministic model (4)

Answer 340

1. It may be difficult to determine which economic scenarios to test
2. May not cover a sufficient range of outcomes to base a decision on
3. Does not explicitly allow for all possible interactions between variables
4. It is not a good model for valuing options and guarantees as it is difficult to model the variability and take a parades or the guarantee biting

Question 341

Why there is a lower level of anti-selection in group risk products (5)

Answer 341

1. Membership of group schemes is often COMPULSORY
2. or a high proportion of those eligible will join.
3. Usually, all members of the scheme receive benefits that are the same or are determined by a fixed formula
4. There should be less opportunity then for good risks to decide not to join, or for poorer risks to buy more cover
   — Group membership is hence expected to be a mixture of good and bad risks.
   — which will also be fairly constant over the course of the usually annual contract.
5. Generally we expect people that are able to work (or start a new job) to be in reasonable health

Question 342

Before seeing a client, the actuary should consider:

Answer 342

1. Information in the public domain, e.g., accounts; websites
2. A pre-project meeting with the client
3. Attitude of client —> risk appetite and culture
4. Potential conflict of interest
5. The circumstances and objectives

Question 343

The effects that state benefits will have upon the provision or purchase of additional benefits by employers and employees (6)

Answer 343

1. Raise awareness among employees of the importance of certain benefits
2. Raise employees’ awareness of the need to invest in or purchase top-up benefits
3. Increase pressure on employers for the need to provide top-up benefits for employees
4. Conversely, it may introduce moral hazard where individuals rely on state benefits based upon the assumption that ‘the state will provide’
5. Reduce levels of additional saving if state benefits are means-tested
6. Where state benefits are contributory, make individuals less able to provide for themselves or make them feel that they cannot do so.

Question 344

How do regulators ensure confidence in the financial system? (3)

Answer 344

1. Checking ongoing solvency (capital adequacy) of authorised providers
2. Enforcing strict accounting information requirements
3. Ensuring the competence and integrity of financial practitioners

Question 345

How do regulators help to reduce financial crime? (5)

Answer 345

1. Vetting (investigating and approving) the firms authorised to conduct certain activities
2. Vetting the individuals authorised to conduct certain activities
3. Enforcing regulations
4. Investigating suspected breaches of regulation
5. Imposing sanctions if regulations have not been met.

Question 346

The basic regulatory requirements that a stock exchange ought to satisfy in order to obtain authorisation to act as an exchange (12)

Answer 346

FINANCIAL RESOURCES
1. It has adequate financial resources to provide the requisite exchange services
2. Traders and brokers dealing on the exchange also have adequate capital
BUSINESS RULES
3. Proper conduct of business rules exist, in particular …
4….all parties (traders and issuers of securities) should be aware of the rules and understand them
5. These rules are monitored to ensure they are enforced…
6…. to prevent insider trading and fraud
PROCEDURES
7. it operates proper, transparent and sufficiently liquid markets in the securities traded
8. appropriate procedures for recording transactions exist, e.g. time, price and volume of each trade, and the parties involved
9. appropriate procedures exist for admitting new listings, …
10… including obliging the companies to fulfil certain financial and accounting requirements in order to both secure and subsequently maintain the listing
11. Proper arrangements exist for the clearing of transactions …
12… Including recording the time, price and volume of each trade in order to prevent fraud and insider dealing.

Question 347

Advantages of means-testing benefits (2)

Answer 347

1. Will REDUCE the COST of State benefit provision - since some people (higher income) will no longer be eligible for the benefits.
2. Such a change may be viewed as FAIR, i.e. it helps redistribute wealth

Question 348

Disadvantages of means-testing benefits (4)

Answer 348

1. Means testing involves more complicated ADMINISTRATION and increases costs
2. May result in individuals FAILING to CLAIM ENTITLEMENTS. This is because people may feel it is demeaning to claim benefits or may not understand the process.
3. Can act as a DISINCENTIVE TO SAVE
4. Reduction in benefits will make people worse off

Question 349

Risk-return measures (2)

Answer 349

1. Risk-Adjusted Return on Capital (RAROC)
   =risk-adjusted return / Capital
   • Compare RAROC to Cost of Capital
   • Compare actual vs expected return on capital
2. Economic Income Created
   =(RAROC - hurdle rate) * Capital
   • Captures the quantity of return generated by unit of activity
   • if proposed activity does not offer a RAROC > Hurdle rate, activity is rejected

Question 350

How does the amount capital allocated to a business unit affect it? (4)

Answer 350

1. Determines the business unit PERFORMANCE (e.g. by RAROC)
2. Could affect, directly or indirectly, the REMUNERATION of the units managers & consequently, their level of MOTIVATION and behaviour
3. Dictates the AMOUNT of BUSINESS the business unit can write (as each product consumes capital & the total amount of capital is limited)
4. Determines the PRICE at which business can be written (e.g.: a min price might be determined by a stipulated min RAROC)

Question 351

How could disclosure help to improve the security of non-state provision (3)

Answer 351

1. making the operation of the scheme more transparent and so subject to scrutiny
2. alerting members and trustees to potential problems, possibly enabling them to put pressure on the scheme sponsor to address these potential problems
3. providing members with the opportunity to leave the scheme if they are not happy with the level of security offered.

Question 352

Why does the share price often stand at a discount to NAV in a Closed-Ended Fund (6)

Answer 352

Share Price =Market capitalisation/ Number of Shares
NAV per share = Value of company’s underlying assets/no. of shares
The market capitalisation of the investment trust company (ITC) is lower than the value of the underlying investments held by the ITC because:
1. ITC maybe out of favour with investors do you to corporate/management issues
2. There may be a general fall in equity markets not echoed in the value of the underlying unlisted assets
3. The expenses & running costs in the ITC need to be allowed for in the pricing and hence deducted from any income generated by the underlying asset
4. Have to pay for management skills of those picking the underlying investments
5. The shares of the ITC maybe more illiquid and this may reflect in the pricing as they will be less attractive
6. Loss of control in the underlying asset when investing in the ITC —> less attractive

Think if the disadvantages of CIS

Question 353

Risk measures: Deterministic approaches (3)

Answer 353

1. notional approach
2. the factor sensitivity approach
3. the scenario sensitivity approach.

Question 354

Risk measures: probabilistic approaches (4)

Answer 354

1. Deviation
   — standard deviation - deviation is measured from the mean
   — tracking error - deviation is measured relative to a benchmark
2. Value at Risk (VaR) - the maximum potential loss on a portfolio over a given period with a given degree of confidence
3. Probability of ruin - the probability that the net financial position of an organisation or line of business falls below zero over a defined horizon
4. Tail Value at Risk (TVaR).

Question 355

For risks that are retained, the risk portfolio would also contain details of (5)

Answer 355

1. control measures
2. reassessment of value and impact after controls
3. risk owner
4. board committee/senior manager with oversight of the risk
5. identification of concentrations of risk and related actions.

Question 356

Need for regulation (2)

Answer 356

1. Ensure confidence in the financial system
   — by guarding against the dangers of problems in one area spreading to other parts of the system, and the damage that would be done by a systemic financial collapse.
2. Compensate for any asymmetries in financial transactions
   • information
   • expertise
   • negotiating strength

Question 357

Direct costs of regulation (2)

Answer 357

1. regulator in administering the regulatory framework,
   — eg collection and examination of information required for monitoring purposes
2. regulated firms in complying with the regulation,
   — eg in maintaining appropriate records, collating requisite information and supplying it to the regulator and/or the investor.

Direct costs are ultimately borne by the consumer in the form of either higher taxation and/or higher charges

Question 358

What criteria should an investment objective for an institutional investor satisfy? (3)

Answer 358

1. Clearly stated
2. Quantifiable
3. Framed in terms of risk, total required return and timing of cashflows

Question 359

Experience is running much worse than expected. What would a statutory actuary need to do to allow for this worsening of experience in the valuation? (5)

Answer 359

1. Set up a deficiency reserve for all the existing policies.
2. This reserve will need to be the difference between the actual experience versus what is allowed in the pricing (which is the expected experience)
3. This will need to be calculated over the entire future lifetime of all existing policyholders and discounted back using an appropriate risk discount rate.
4. The risk discount rate should reflect the likely investment return that could be earned between the date the reserve is set up and when the reserve is likely to be needed to fund the difference between the actual and expected experience.
5. You should take the effect of likely lapses into account when doing the calculations as well.

Question 360

Potential attractions of emerging markets (6)

Answer 360

1. Rapid economic growth
2. Better diversification
3. Inefficient markets: buy cheaply
4. Perceived to be risky: buy cheaply
5. Might offer industries to invest in that are not available elsewhere
6. If you have liabilities in that market you can match them with assets from that market

Question 361

Potential drawbacks of emerging markets (6)

Answer 361

1. Lack of quality information - requires local expertise
2. Poor regulation of the stock market
3. High levels of volatility
4. Tight controls on ownership by foreigners
5. Repatriation problems
6. Might not have double-taxation agreements with your country and therefore cannot recover withholding taxes

Question 362

Investment and risk characteristics of money market instruments (9)

Answer 362

S- Generally very low default risk due to short term (although depends on issuer)
Y- Expected return lower than on most other asset classes
Y- Return expected to move broadly in line with inflation
S- Stable market values due to short term
T- Term: short
E- Very low dealing expenses
M- Marketable (with the exception of call and term deposits)
Liquid
T- Usually taxed as income

Question 363

investment and risk characteristics of conventional government bonds (10)

Answer 363

S- very good security (in politically stable countries)
— depends on the issuer and their credit rating
— Usually negligible default risk if a developed country.
Y- Income = coupons (usually semi-annual) fixed in nominal terms.
Y- Capital = redemption payment (usually at par) fixed in nominal terms.
But trading
— coupons would be reinvested on terms that are unknown at outset
— if an investor sells before redemption, sales price is unknown
Y- Lower long-term expected return than equities and property.
Y- Provides a fixed nominal return. Real return eroded by actual inflation.
S- Volatility of capital values higher for long-term than short-term bonds.
— market values change according to the supply and demand
T- Term: short, medium, long, irredeemable
E- Very low dealing costs if a developed country.
M- Very marketable if a developed country.
— depends on the issue size
T- Tax treatment depends on the territory.
— both an income and capital gain component
— income and capital gains tax for individual investors
— institutional investors pay a uniform rate of return
— pension funds are exempt

Question 364

Factors to consider when using results from experience investigations into assumptions (8)

Answer 364

1. Purpose of the assumptions
2. Significance of assumption(s) on the overall result
3. Relationship/consistency between the assumptions
4. The needs of the client
5. Legislation/regulation constraints
6. Margins in assumptions vs RDR
7. Time horizons over which the assumptions will apply
8. Credibility of results and hence the need for margins

Question 365

Describe how accounting standards may affect employer benefit provision and the financial products brought to market. (3)

Answer 365

1. The way that benefit schemes need to be reported in company accounts may influence the TYPES OF BENEFITS that employers are prepared to provide for their employees.
2. The presentation of financial instruments in the accounts of product providers also impacts on the range of products that is brought to market.
   For example, the different accounting requirements for setting the provisions for different types of insurance contract in different territories can influence the design of contracts.
3. Similarly whether a fund manager brings investments to market within an insurance wrapper in a subsidiary company, or through a collective investment scheme, might depend on the presentation and results shown in the company’s accounts.