Part 4

Question 1

Factors to consider when Pricing life insurance contracts

Answer 1

• Mortality Investment return assumption risk margin
• Expense and commission
• Dealing with per policy expense
• Inflation of expense
• Persistency
• Margins Discount rate

Question 2

Market consistent approach to valuating liabilities

Answer 2

• a. To determine the liabilities, unknown parameter values and cashflows are set so as to be consistent with market values, where a corresponding markets exists
• It maybe difficult to obtain a “market consistent” assumption for some elements of the basis, such as mortality, persistency or expense, for which there is not a sufficiently deep and liquid market in which to trade or hedge suck risks
• The starting point for such assumptions will be the best estimate d. It is likely that a risk margin would be included in respect to these assumptions to due to inherent uncertainty
• The risk margin would reflect the compensation required by the market in return for taking on those uncertain aspects of the liability cashflow
• Project each future year’s cashflow from the portfolio of existing policies. Each year’s cashflow should consist of expected claims less expected future premiums and expense
• We would allow for the impact of future mortality and lapses, so as to produce expected future cashflows for each year
• In the absence of direct market valuations of mortality and lapse risks, the company would use best estimate assumptions of the future experience for these parameters, plus a risk margin to represent the price of the market might expect to pay in order to compensate for the uncertainty
• Each years expected cashflow would then be discounted at the appropriate risk free rate of return
  
  • This could be the government bond yields or on swap rates of suitable term to match the liabilities
  • May be appropriate to make a deduction to the bond yields/swap rates to allow for credit risk
  • May take credit for the illiquidity premium in corporate bonds and thereby use a higher discount rate than the risk free rate
• The value of cashflows discounted at their appropriate risk free rate plus the risk margin would be the market consistent valuation of the liabilities
• The risk margin could be included by adding a margin to the mortality and lapse assumptions
  
  • Alternatively, an overall reserving margin in respect of these risks could be determined using the cost of capital approach as follows
  • Firstly project the required capital at each future time period ii. Multiply the projected capital amounts by the cost of capital
  • Discount using market consistent discount rates to give the overall risk margin a. Are there cohort effect

Question 3

Factors to consider when setting assumptions

Answer 3

1. General factors to consider
   
   1. Degree of prudence required for supervisory reserving or pricing
   2. Margins that should be used
   3. Company’s past experience
   4. Allowance for future trends
   5. Assumptions used last time
   6. Assumptions used for other companies
   7. Assumptions being used by this company for other purposes
   8. Regulation and professional guidance b. Investment return
2. Asset mix held
   
   1. Expected return on those assets
   2. Low unit growth should be used if we want to be prudent
3. The assumed asset mix of the fund could be based on the actual holdings at valuation date.
4. Investment return could be based on rfr rate.
5. For demographic assumptions
   
   1. Past experience
   2. Mortality is most likely taken from standard table adjusted for the company’s own experience
   3. High mortality
   4. Surrender would be prudent
6. Assume that future charge income would exceed future expense and additional benefit outgo
7. Expense assumptions
   
   1. Use a recent company expense analysis as a base
   2. Expense should include appropriate share of overheads
      
      1. Which may involve considering future new business volumes
      2. Allow for expense inflation
      3. Higher assumed expense and inflation would be prudent
   3. For future charge income
      
      1. Low assumed AMC
      2. Low assumed CPI would be prudent
8. For Interest rate
   
   1. Use swap rates or government bond yields for RFR
   2. Low RFR is prudent

Question 4

Market consistent valuaton of liabilities how do they measure it

Answer 4

1. Market consistent
   
   1. Investment return is based on risk free
      
      1. Based on government bond yields
      2. Illiquid premiums could be taken into account and discount liabilities at a higher rate
   2. To determine the liabilities,
      
      1. The future unknown parameter values and casflows are set so as to be consistent with market values, where a corresponding market exists
      2. The assumed future investment returns are based on risk free rate of return, irrespective of the type of assets actually held and the discount rates are also based on risk free rates
      3. We could take credit for illiquidity premium and thereby discount liabilities at a higher yield than the risk free rate
      4. This would normally be restricted to long term predictable liabilities
      5. For non hedgable risks it is difficult to obtain a “market consistent” assumption as there is not a sufficient and deep liquid market in which to trade to hedge these risk so a margin is required
      6. Expense and longevity are mostly un-hedgable
      7. Margins should reflect compensation required by the market in return for taking on those uncertain aspects of the liability outflow
         
         1. Cost of capital approach could be used.
      8. This is overall reserving margin
      9. Illiquid premium
         
         1. If business is exposed to long term liabilities then they do not need to worry about liquidity

Question 5

Why is solvency important

Answer 5

• It is important for a company not just to be solvent now, but to be confident that it will continue to be solvent in the future.
• This is important for external stakeholders, eg regulators who are concerned with protecting policyholders, and so projecting the future solvency position may be a regulatory requirement.
• Projecting its solvency position will enable a company to assess the impact of future adverse events and its ability to withstand them.
  
  • These may be one-off shocks, eg market crash or flu pandemic
  • more gradual changes, eg in the company’s demographic experience.
• improve its risk management
• Improves the company’s ability to write new business, by covering development costs and new business strain
• demonstrate sufficient financial strength to attract customers.
• The future solvency position will affect a company’s future investment strategy.
  
  • ln particular, the stronger the projected solvency position, the less constrained the investment policy may be, enabling the company to mismatch if it chooses in pursuit of higher expected returns.
  • Projecting the future solvency position will help the company plan for any future capital raising that is required … …
  • Plan any returns of capital to its capital providers, eg payment of dividends to shareholders.
• It can be used to assess the company’s ability to exploit future opportunities, eg to buy another company or block of business, which may generate higher returns.
• to inform management decision making
  
  • to assess the effectiveness of risk management strategies, eg reinsurance
• to measure the probability of ruin.

Question 6

How to improve solvency

Answer 6

1. Retaining profit
2. Hold more prudent assumptions. This should increase the amount of assets emerging in the future
3. Writing less business. This will reduce the NB strain but will only work in the short term.
4. Changing the business mix. Selling only less capital intensive products
5. Product design
6. Defer profit distribution
   
   1. Changing to super compound from compound
   2. Increase terminal bonus
7. Switch assets so that we can use a higher valuation interest rate
   
   1. Illiquidity premiums
8. Investment matching
9. Reinsurance
   
   1. Original terms
   2. Reducing claims fluctuations
   3. Spreading the reinsurance
10. Financial reinsurance
    
    1. Capital loan
    2. Risk Premiums - initial commission is paid out, higher premium in the future is paid out
11. Underwriting reducing
    
    1. Anti-selection
    2. Correct premiums
    3. Claims experience is no worse than the assumptions used in the premium basis
    4. Correct per price policy expense assumption is met
12. Experience monitoring
    
    1. Regularly monitor the actual experience of the company and check that the pricing assumptions and reserve basis are appropriate
    2. Identify the reason for the adverse effect
13. Any results from relevant investigation should be communicated to the directors

Question 7

Surrender Principle

Answer 7

PALACE DICE

1. PRE
2. Asset shares Not exceeding earned asset shares, in aggregate, over a reasonable time period.
3. Later durations – the value of the surrender should be consistent with maturity values. Ensure that at the beginning the SV is asset share, then moves to premium basis and eventually at releastic basis towards maturity.
4. Avoid discontinuities- seleciton against the company
5. Continuing policyholders - treating them equitably in comparision to the surrendered customers
6. Early durations – premiums retrospective method, then early transfer values would likely be more generous.
7. Document clearly
8. Infrequent changes
9. Competition
10. Ease of calculation
11. Provide a fair contribution to profit
12. Auction values are often determined prospectively and so the surrender value may not be consistent with these, especially late in the policy term.
13. The prospective method is more likely than the retrospective method to produce comparable transfer values to those offered by competitors
14. … Since retrospective method is a proxy for AS.
15. take into account policyholders’ reasonable expectations
16. not exceed earned asset shares, in aggregate, over a reasonable time period
17. Using a prospective, rather than retrospective, method means that there is no guarantee that this principle will be met
18. be consistent with projected maturity values at later durations .
19. not be subject to significant discontinuities by duration .
20. treat both surrendering and continuing policyholders equitably
21. Using best estimate assumptions in a prospective valuation means that the company is expecting to retain the same profit as if the contract had not been transferred. In this case the principle is not met.
22. not appear too low compared to premiums paid in early years, taking into account any projections given at the new business stage
23. be capable of being documented clearly .
24. not be subject to frequent change, unless dictated by financial conditions
25. take account of surrender values offered by competitors and possibly also auction values, where available .
26. not be excessively complicated to calculate.

Question 8

Alterations

Answer 8

AB Safe 1. Affordability 2. Boundary conditions 3. Stable 4. Avoid Lapse and re-entry 5. Fair 6. Easy to calculate

Question 9

Principles of alterations

Answer 9

1. Terms should be affordable
   
   1. Supported by asset share
2. Should comply with relevant boundary conditions
   
   1. Additional premiums to provide for additional benefits, this should be on terms consistent with a new policy for just those additional benefits
      
      1. The terms should be consistent for new policy with benefit that are equal or proportionate to the additional premiums
      2. A reduction of terms towards zero should be consistent with surrender value
      3. Premiums charged look consistent with the difference between the surrender value and the maturity
   2. A reduction of premium towards zero should be consistent with paid up policy terms offered
      
      1. Premiums after paid up should approach 0 as the benefit approaches the paid up value
   3. Increasing the sum assured is analogous to keeping the original policy and purchasing an incremental policy at current premium rates
   4. Alterations should be stable,
      
      1. Small changes in benefits should result in small changes to premiums if expenses of alterations are ignored
      2. Alterations terms should avoid the option of lapse and re-entry
   5. Alterations should be fair
      
      1. The profit expected from the contract after the alteration should be the same as the that before, or alternatively the same as the expected amount had the policy been written originally on its altered term
   6. Alterations should be fair, ie they should make a suitable amount of profit for the company, for example the amount of profit that would have been made had the policy not been altered or an amount that is consistent with what would be made on a new policy.
   7. To avoid anti selection the company may want to underwrite some alterations, particularly those where it faces increased risk e.g. the additional of a spouse
   8. Easy to calculate and easy to document and explain to policyholders
   9. The cost of administering the alterations should be factored in the terms offered
   10. The cost of underwriting should also be included in the alterations costs allowed for

Question 10

What is embedded value

Answer 10

1. Embedded value is the present value of future shareholder profits in respect of the existing business of a company, including the release of shareholder-owned net assets.
2. It can be calculated as the sum of:
   
   1. the shareholder-owned share of net assets, where net assets are defined as the excess of assets held over those required to meet liabilities.
   2. These assets may be valued at market value or may be discounted to reflect ‘lock-in’, for example if they are required to be retained within the fund to cover solvency capital requirements.
   3. The present value of future shareholder profits arising on existing business. The calculation of future profits may differ for different types of business.
      
      1. For conventional without-profits business, future profits at each future time are premiums + investment income - claims - expenses + release of solvency reserves.
      2. For unit-linked business, future profits are charges (including surrender penalties) - expenses - benefits in excess of the unit fund + investment income earned on non-unit reserves + release of non-unit reserves.
      3. For with-profits business: the future profits are future shareholder transfers, for example as generated by bonus declarations.
   4. Additional For conventional without-profits business and unit-linked business, embedded value is effectively the release of any margins within the solvency reserves relative to the assumptions used within the embedded value calculation.
   5. The assumptions used are likely to be prudent for the solvency reserves and realistic for the profit projections.
   6. ln the calculation of net assets, it is important that the reserves used are consistent with those used in the determination of the present value of future profits.
   7. This may be different for different types of business.
      
      1. For conventional without-profits and unit-linked business, the reserves may be taken to be the solvency reserves
      2. For conventional with-profits business, the reserves may be taken to be the amount supporting the future bonus declarations. There are different ways in which this can be determined, eg based on asset shares or such as to gradually distribute the estate. The proportion of the net assets which is shareholder-owned is also likely to differ for different types of business.
3. Tax is allowed for within the calculation as appropriate.

Question 11

Equating policy values

Answer 11

• The costs associated with carrying out the alteration would be allowed for.
• The company could use the method of equating policy values, where the value of the contract before alteration, on a prospective or retrospective basis, can be equated to a prospective value after alteration that takes into account the requested changes to the terms ofthe contract.
• This method recognises some value from the original contract and uses this to reduce the premium that would otherwise be charged for the post-alteration contract.
• The method and basis chosen for the before and after alteration values will affect the amount of profit the company takes from the contract at the alteration date and the amount of profit it expects after the alteration date.
• Charge usual premium for new contract The company could therefore charge the usual premium as for a new endowment contract
• This may be subject to some discounts, eg to reflect the lower costs of altering the policy compared to selling a new policy

Question 12

How Non - Unit Reserve is calculated

Answer 12

1. To calculate the non-unit reserve it is necessary to consider the year-by-year (and, at the outset of the contract, possibly the month-by-month) incidence of the various components of the non-unit cashflows.
2. A discounted cashflow method needs to be used.
3. The company should project forward its non-unit cashflows (eg charges, expenses, benefits in excess of the unit fund) on the reserving basis.
4. This may need to be performed on a policy-by policy basis.
5. The projection of some of the non-unit cashflows, eg annual management charge, will require the projection of the unit fund over the period.
6. Assuming the supervisory regime requires prudent reserves to be held, the non-unit reserve can then be calculated as follows:
7. Start with the last projection period in which the net cashflow is negative.
   
   1. An amount is set up at the start of that period which is sufficient, allowing for earned investment return over the period, to ‘zeroise’ the negative cashflow.
   2. This amount is then deducted from the net cashflow at the end of the previous time period.
   3. The process continues to work backwards towards the valuation date, with each negative being ‘zeroised’ in this way.
   4. When the process has been completed, if the adjusted cashflow at the valuation date is negative then a non-unit reserve is set up equal to that negative amount.
   5. The non-unit reserves could be negative under certain circumstances, eg if supervisory reserves were required to be calculated on a best-estimate basis.

Question 13

The practicalities of generating transfer/surrender values

Answer 13

1. The actuarial model will need to be run on the pricing basis as well as the valuation basis.
2. This may require amendments to the current valuation model…
3. … e.g. if pricing is done using a yield curve and the valuation is done using a single rate of interest.
4. It may be difficult to produce transfer values in the required timeframes.
5. It needs to consider what an appropriate turnaround time standard for transfer value requests is.
6. It needs to consider whether a full run of the actuarial valuation model is required for each request…
7. … or whether alternative approaches could be used. Such as using sensitivities and market indices.
8. It needs to consider whether economic assumptions/market data are available at mid-points in the month.
9. And what happens if there are material market movements. The company may need to create trigger points above/below which sensitivities become invalid.
10. The company needs to decide which department will provide the transfer values.
11. It may not be appropriate for the actuarial valuation team to do so, as more likely to be dealt with in a customer service area.
12. So they would require training on the process. [There may be a high number of requests arriving at the same time. [1]
13. The company may need to take on extra resources. [1]
14. It will need to design and produce transfer value documentation/statements.
15. [1] The implementation and development costs will need to be considered.
16. [1] As will the cost of processing each transfer value. [1]
17. If there is poor customer service this could generate additional demand.

Question 14

Advantages and disadvantages of Retrospective

Answer 14

• It represents the maximum that the company could pay without making a loss
• At early durations it may be reasonable compared with the premiums paid
• For without - profit contracts, its not easy to ensure equity either with continuity policyholders or with any shareholders
• For without profit contracts, it will not run into the maturity value, except by chance
• Values may be significantly different from a realistic prospective value, which is likely to be the approach used to calculate auction values
• Consistency with competitors depends on the method and basis used
• It may be consistent with values quoted in product disclorsure literature
• The most complex component of method is obtaining the necessary historic information

Question 15

What is passive valuation approach and state 3 aadvantages

Answer 15

• A passive approach is one which uses a valuation methodology which is relatively insensitive to changes in market condistions and a valuation basis which is updated relatively infrequently
• The advantages are that they
  
  • Tend to be more straightforward to implement
  • involve less subjectivity
  • results in relatively stable profit emergence

Question 16

Define what active valuation approach is and state the advantages

Answer 16

• An active approach would be based more closely on market conditions (than passive valuation), with the assumption being updated on a frequent basis
• Active valuation approaches are more informative in terms of understanding the impact of market conditions on the ability of the company to meet its obligation, particularly in relation to financial guarantees and options

Question 17

Impact of moving from active approach to pasive

Answer 17

• Moving from a passive to active valuation approach will mean:
• Moving from a valuation approach which is relatively insensitive to changes in market conditions… [½]
• … to one where the valuation changes as market conditions change. [½]
• Valuation assumptions will need to be updated more frequently under an active valuation approach. [1]
• This will increase the workload demands on the companies. [½]
• More frequent reporting may also be required, further increasing workload. [½]
• The concept of ‘locked-in’ assumptions (if used) would no longer be appropriate under an active valuation approach. [½]
• Assets would be valued on a different basis… [1]
• … moving from historic / book value to market value. [½]
• The calculation of the solvency capital requirement may change… [1]
• … a higher capital buffer may be required to protect against the increased risk of future adverse volatility. [½]
• The calculation may move from a relatively simplistic approach to a risk-based capital approach. [½]
• There may also be a material day 1 solvency capital impact of implementing the new approach. [½]
• Active approach requires more subjectivity… [1]
• … this may lead to companies’ results becoming more volatile under an active approach. [½]
• This then requires companies to spend more time explaining this volatility to financial markets… [½]
• … and be exposed to the risk of a falling share price if listed. [½]
• Under adverse market conditions e.g. a large fall in equity markets an active valuation approach can exacerbate the fall… [½]
• … by indicating a sell off of equities to reduce capital requirements. [½]
• The change may increase the need for sensitivity testing – possibly at the request of the regulator. [½]
• As a result, companies would become more informed about the impact of market conditions on financial options and guarantees. [½]
• There would be greater costs for the companies… [½]
• … higher running costs, [½]
• … costs from projects to ensure a smooth transition from a passive approach to an active approach,