Past papers 2014

Question 1

Solvency margin

Answer 1

The excess of the value of an insurer’s ASSETS
over its
- TECHNICAL RESERVES
- CURRENT LIABILITIES

Question 2

What is meant by an insurer having an “improved solvency position”?

Answer 2

An insurer’s solvency position is improved if its solvency margin increases relative to its solvency requirement.

Question 3

Outline the ways in which reinsurance can be used to improve an insurer’s solvency position

Answer 3

INCREASING THE VALUE OF THE ASSETS:
- reinsurance commission
- Financial reinsurance can be sought.
— Such arrangements can effectively be loans repaid from the future profits of the underlying business.
— As the “repayments” of the “loan” are contingent on profits they DO NOT APPEAR AS A LIABILITY on the balance sheet, which would have been the case
with a bank loan.

DECREASING THE VALUE OF THE LIABILITIES
- By reinsuring the insurer is reducing the value of its liabilities as some of its
liabilities are ceded to the reinsurer.
- Reinsurance allows the insurer to get a better spread of risks which may result in more certainty in aggregate results and therefore less need for margins in reserves.
- Reciprocal arrangements can also assist with this.
- Non-proportional cover can assist in dealing with:
— large claims; and
— accumulations of risk.
All of the above allow the insurer to hold lower reserves.
However, the assets are reduced by the amount of the reinsurance premium paid.

DECREASING THE REGULATORY MINIMUM SOLVENCY REQUIREMENT:

• The required solvency level is often calculated with reference to the proportion of business reinsured, i.e. more reinsurance means a lower solvency requirement, and therefore a stronger solvency position.
• However, this reduction may be subject to a limit, since there may be a legal requirement for an insurance company’s free reserves to exceed a Required Minimum Margin (e.g. to protect against reinsurer failure).

Question 4

2 Types of “run-off reinsurance”

Answer 4

Adverse development cover

Loss portfolio transfers

Question 5

Adverse development cover

Answer 5

A reinsurance arrangement whereby a reinsurer agrees,
in return for a premium,
to cover the ultimate settled amount of a specified block of business above a certain pre-agreed amount.

• It protects the cedant from significant reserve deterioration on run-off business.
• The premium that is payable for the cover will depend on the risk appetite of the market.
• Usually it is only possible to reinsure a layer above a specified amount, i.e. there is usually an upper limit to the cover.
• The reinsurer may also insist that the insurer has a small participation in the layer.
• Claims are usually still handled by the insurer and hence there are the associated expenses.
• Reserves are maintained by the insurer (as opposed to being transferred to the reinsurer) and it receives all INVESTMENT INCOME generated from the investments backing these reserves.
• The insurer is exposed to the CREDIT RISK of the reinsurer, since the insurer remains liable to the insured parties for all claims within the block reinsured.

Question 6

Loss portfolio transfers

Answer 6

An arrangement whereby the liability for a specified book of business is passed in its entirety from one insurer to another.

• Policyholders will be informed of this “novation” (the transfer of rights and obligations under a contract from one party to another) and the deal may need to be approved by a court.
• Novation is not strictly reinsurance since the new insurer is responsible for the liabilities in total from the date of the transfer.
• The original insurer will transfer the reserves and the remaining exposure to the new insurer.
• It is likely that there will be a premium in addition to the existing reserves (to compensate the accepting insurer for taking on the risk and for the cost of the transfer).
• This would normally include a claims handling service.
• Assets may need to be realised to pass across the value of the reserves to the accepting insurer (which is particularly important if there is mismatching or if tax gains / losses would be crystallised).
• If the new insurer defaults, this could damage the reputation of the original insurer.
• The transfer may require the buy-in of reinsurers where there are existing reinsurance arrangements covering the portfolio.

Question 7

Explain how selling through independent brokers may increase liquidity risk for the company

Answer 7

Liquidity risk may increase because:

• Brokers often collect premiums on behalf of the insurance company.
• This money will accrue as income to the insurer, but is not available as cash until the broker has paid it through to the insurer.
• This may affect the insurer’s ability to meet its obligations.
• – This is particularly so if the money is paid later than expected.

Question 8

Outline the relative ADVANTAGES of selling business directly to the public

Answer 8

• The company has greater control over the remuneration of sales staff. (Brokers to an extent dictate the remuneration rates particularly in markets where broker business is dominant.) This may allow COST SAVINGS or better alignment of incentives.
• Sales-staff are selling ONLY YOUR PRODUCTS. Brokers may have a number of products from other companies that compete with yours and will sell the most appealing (to them) first.
• The company retains CONTROL OF THE TARGET MARKET by selling direct. There is no guarantee that brokers are selling to the desired target market.
• It can give the company greater CONTROL OVER SALES VOLUMES, e.g. the ability to stop selling business to a certain category of policyholders by simply instructing call centre agents, rather than having to communicate to all brokers.
• The company may increase its potential reach and hence sales volumes. This is particularly important as direct selling is an expanding market and if the company does not start selling direct, competitors may gain a first-mover advantage.
• It can be an EFFICIENT way of selling business (e.g. can run one training session for all sales staff rather than visiting brokers separately), and result in some long-term
  cost savings.
• MANAGEMENT INFORMATION should be able to be accessed more quickly as it will be directly loaded onto the company’s systems – no need to collect data from
  brokers.
• Premium rates do not need to be as competitive as is required when selling via independent intermediaries as potential policyholders cannot compare quotes as simply as when buying through brokers. This could allow GREATER PROFIT to be
  made.
• There will be a REDUCED LIQUIDITY RISK in that brokers are not holding premiums for the company.
• Selling directly allows active CROSS-SELLING of products as the company has direct contact with customers.

Question 9

Outline the relative DISADVANTAGES of selling business directly to the public

Answer 9

• The company will incur the COSTS of setting up and maintaining an internal sales force.
• Furthermore, this will be a fixed cost (including salaries) compared to broker commission which is only paid when brokers bring in business. This increases fixed costs and the associated risk of not selling enough policies to cover costs.
• Brokers have an existing client base to which they can sell. They therefore can provide the company with more exposure to the market than they may be able to do directly – at least initially.
• Some product features may be COMPLEX, and such products could be difficult to sell directly to the public compared to brokers where they are able to explain product features to potential policyholders.
• It will take time to build up expertise in selling directly. This may make direct selling less effective initially.
• Extra costs will be incurred in establishing brand awareness with the public (through marketing etc.) because in the past policyholders would have known brokers brands, but not the insurer’s brand.
• The policyholders attracted (target market) will likely be different, resulting in pricing assumptions being invalid (if there were cross-subsidies in existing rates based on a certain mix of business).
• Renewal rates may decline (lapses increase) on existing policies if broker business is done away with as policyholders are likely to have some degree of loyalty to their broker, rather than to the insurer. This will reduce policy volumes and reduce the insurer’s ability to recover expenses.
• Renewal rates may decline and lapses increase, impacting on expense recoupment.
• The mix and volume of business attracted will not be known, which could make pricing difficult initially.

Question 10

Explain the problem that is posed by EXPENSE CROSS-SUBSIDIES between different LINES OF BUSINESS

Answer 10

• Premiums for one class will be higher than they would be if they were only covering the costs of that book as they are also covering some expenses from the book of business.
• This increases the risk that the insurer’s policies are overpriced relative to competitors’ policies hence competitors attract business away from this insurer.

Question 11

Steps in an expense investigation / allocation to minimise cross-subsidies

Answer 11

GOAL OF THE EXERCISE:

• The goal of this exercise is to determine which expenses are as a result of writing each of the products, so that the cost of writing each product can be determined.
• This cost will then be compared to the current expense loading for each product to see if there is indeed an expense cross-subsidy.
• The expense loading can be calculated by taking the gross premium and subtracting the expected claims cost and other loadings (e.g. capital loading and a negative loading for investment income).

COLLECT DATA:

• Data on all expenses must be collected.
• This is to ensure that the expense allocation to each product sums to the total expenses of the company.
• Data items to be collected include number of policies, premium volumes, etc.

ALLOCATE COMPANY EXPENSES BETWEEN PRODUCTS

The first step is to split expenses between direct and indirect expenses.

• – Direct expenses can be directly attributed to each product book
• – There may be certain expenses that can’t be directly allocated because they are shared between products
• It may be helpful to split expenses between fixed and variable expenses because variable expenses are always direct and can be allocated easily to the product they relate to
• Fixed expenses can be direct or indirect.
• Direct fixed expenses, will be easily allocated to the product they relate to.
• However there needs to be a pragmatic allocation of indirect fixed expenses that can’t easily be allocated to a particular product.
  For example:
  — Management salaries or admin staff salaries for staff that work on more than one product. Allocation may be in proportion to premium volumes or using staff timesheets.
  — Property costs can be allocated by charging each department a notional rent according to floor space occupied and then allocating this rent to products in the same proportions as salaries of staff in each department.
  — Computer costs. Spread cost over its useful lifetime and split according to how the salary of the staff member who uses the computer is split.
  — Investment costs. Split based on the contribution of each product to the level of investible assets.
  — Once-off capital costs. Allocate over useful lifetime and split according to their use. Similar to computer costs.
  — Claims handling costs. If claims assessment is a fixed cost per claim, then the total claims assessment cost can be split between products based on the number of claims experienced on each product or, if only claims above a certain limit are assessed then claims assessment cost will be split based on number of claims above that level. If the claims assessment cost is proportional to the size of the claim, then the total claims assessment cost may be split between products based on total claims.

Commission expenses are likely to be excluded from this analysis (since it is
usually a straight forward percentage of premium per policy).

Question 12

burning cost premium

Answer 12

The burning cost premium is defined as the actual cost of claims during a past period of years expressed as an annual rate per unit of exposure such that:

BCP = (Total Claims) / (Total Exposed to Risk).

Question 13

effective burning cost premium

Answer 13

the burning cost premium using

unadjusted data.

Question 14

indexed BCP (IBCP)

Answer 14

adjusts the claims for past inflation and also includes IBNR

Question 15

Advantages of the burning cost approach

Answer 15

• Simplicity.
• Needs relatively little data.
• Quicker than other methods to perform.
• Allows for experience of individual risks or portfolios

Question 16

Disadvantages of the burning cost approach include:

Answer 16

• Harder to spot trends so it provides less understanding of changes impacting the individual risks.
• Adjusting past data is difficult.
• Adjusting for changes in cover, deductibles and so on may be difficult as we often lack individual claims data.
• It can be a very crude approach.

Question 17

Suggest a formula that incorporates the burning cost premium rate to calculate the office premium to charge

Answer 17

( EXPOSURE × burning cost premium + expected claims costs + policy expenses + vehicle expenses)
/
(1 – commission rate – profit and contingency loadings)

Question 18

Discuss additional factors, including those relating to historical data, that would need to be considered before finalising the actual premium.

Answer 18

Before the final premium is determined, we need to determine whether there are any potential large losses in the historical data distorting the calculations.

• offering preferential rates (taking lower profit) due to other insurance contracts with the policyholder that are highly profitable.
• Need to determine whether there has been any change in the market
• If company doesn’t have the business already, one would also need to consider
  different policy wordings / restrictions expected to reduce claims costs / numbers.
• Need to consider any expected future external events such as changes in legislation that may impact claims costs, expenses, commission or profit allowances.
• Determining whether the policy will be reinsured and whether reinsurance loadings should be included.
• Competitors’ quotes and assumptions made by competitors.

Question 19

Define “funded accounting” and explain why it is used.

Answer 19

Funded accounting is a method of accounting whereby premiums, claims and associated expenses are related to the underwriting year in which the policies start.
The recognition of any underwriting profit is deferred until a subsequent accounting period,
but provision is made for losses as soon as they are foreseen.

It is used where the underwriting year is of fundamental importance, e.g.

• at Lloyd’s (determines who is on risk);
• for reinsurance contracts that operate on a policies incepting basis because for some classes considerably more information is available after three years compared with after only the first year regarding premium payment, claims settlement and making reinsurance recoveries;
• marine and aviation insurance and non-proportional reinsurance.

Question 20

describe key characteristics of “best-estimate reserves” in the context of actuarial reserves.

Answer 20

• POINT ESTIMATE reserve commonly defined as the mean or expected value of the outstanding liabilities after allowing for areas of uncertainty.
• It may also be defined as the MEDIAN of reserves i.e. equally likely that the true claims value will be above or below this value.
• The best-estimate is the Actuary’s subjective derivation of the outstanding liabilities. It takes into account all available information to date and is based on the Actuary’s selected reserving model and assumptions.
• not inherently optimistic or pessimistic.
• Not meant to contain margins.
• be based on sound and appropriate actuarial or statistical techniques and on current and credible information.
• Different actuaries may calculate different best-estimate reserves based on the same information i.e. it is the actuary’s subjective view.
• Best-estimate reserves do not provide any information on the variance.
• A range of best-estimate reserves may be provided instead of a single best-estimate reserve.
• The actuary should specify what is included in the best-estimate e.g. expenses, salvages, etc.

Question 21

5 Types of uncertainty and potential errors in the range of best-estimate reserves

Answer 21

• PROCESS UNCERTAINTY
  This is the randomness of the underlying process.
  The occurrence, severity and reporting delays of claims is an inherently random process and there will always be some randomness.
• PARAMETER UNCERTAINTY:
  Uncertainty in selecting the parameters within the reserving process.
• MODEL ERROR
  Uncertainty arising from the fact that an inappropriate model may be selected.
• Errors due to INCORRECT DATA
  Incorrect data could lead to incorrect parameters.
• SYSTEMIC ERROR
  Uncertainty arising from unforeseen trends or shifts away from the current claims environment.

Question 22

Facultative reinsurance

Answer 22

Facultative reinsurance is a reinsurance arrangement COVERING A SINGLE RISK as opposed to a treaty arrangement; commonly used for very large risks or portions of risk written by a single insurer.

There is NO OBLIGATION for the ceding company to offer the business, nor is the reinsurer obliged to accept it.
Each case is considered on its own merits and the reinsurer is free to quote whatever terms and conditions it sees fit to impose for that risk.

Question 23

Advantages of facultative reinsurance

Answer 23

• Because the insurer is not obliged to reinsure the risk it allows the insurer to better FINE-TUNE its reinsurance cover.
• The insurer can make use of several reinsurers to help DIVERSIFY its reinsurance cover.
• The insurer can seek the BEST TERMS AVAILABLE at the time cover is required.
• The insurer is ABLE TO WRITE LARGE/UNIQUE risks which are beyond the scope of any treaties.

Question 24

Disadvantages of facultative reinsurance

Answer 24

It is a TIME-CONSUMING (and costly) exercise to place the reinsurance when required.

• It is NOT CERTAIN that the required cover will be available when needed.
• The price and terms offered for the cover may not be acceptable.
• As the reinsurer will need to protect itself against anti-selection terms are not likely to be attractive.
• It is unlikely that the insurer will have access to financing commission to help offset initial expenses.
• The insurer may not be able to accept large risks automatically (until it finds appropriate reinsurance), which may reduce sales and its standing in the market.

Question 25

Advantages of a stability clause

Answer 25

• In an inflationary environment it will help to MAINTAIN THE SAME REAL VALUE OF COVER provided.
• It will help keep premiums down, since without this the reinsurer would have had to make an allowance for the erosion of the excess point by inflation.

Question 26

Outline briefly eight data issues specific to reinsurers accepting inwards reinsurance that you should consider when calculating the IBNR reserves

Answer 26

 Longer reporting delays as reinsurers need to incorporate the insurers’ delay in receiving information.
 Greater tendency for claims to develop upwards for non-proportional business.
Longer reporting delays for larger claims gives more time for economic and social factors to increase the claim.
 Greater level of heterogeneity as reinsurers accept business from many insurers each possibly selling a diverse range of insurance products.
 Sparse data particularly for high excess reinsurance, as the reinsurer is only notified of claims close to the excess points which are rare.
 Reduced applicability of industry benchmarks arising due to heterogeneity of exposures.
 Data and systems, reporting of aggregate information especially for proportional business means less detail is available to the reinsurer.
 Data grouping for reserving can be challenging given heterogeneity of experience.
 Case estimates may not be consistently calculated i.e. the methodology is likely to be different for different insurers and so incurred claims data can produce distorted results.
 Data may be out of date and so not as relevant due to longer reporting delays.
 Errors in data may not be easily picked up given that the reinsurer does not have access to the same level of detail as the insurer.
 Data quality may vary and depends on the quality of the data received by all insurers.
 Layout and format of data are likely to differ between reinsurers which may complicate the analyses.
 Data may not be recorded consistently between insurers, and with the same
insurer over time.
 Data may not be complete for non-proportional claims as the reinsurer only receives information in excess of the deductible

Question 27

Explain how a surplus reinsurer is likely to respond to the situation where several claims in a year exceed the EML.

Answer 27

The reinsurer would NOT BE PLEASED as this may indicate that the insurer is not able to estimate its risks correctly and thus the insurance premiums may be too low.

Even though the premium is shared proportionally with the reinsurers, if the premium is too low they will receive too little premium.

 They have no choice but to pay the claims now.

 If this continues they may be unwilling to renew the reinsurance treaty.

 The reinsurer may require the introduction of some sort of rule regarding the relationship between EML & SI, e.g. the EML cannot be below a certain % of the SI.

 The reinsurer may choose to do nothing if the impact is not significant.

Question 28

Define what is meant by a risk factor

Answer 28

A risk factor is a factor or characteristic of the insured that is expected, possibly with the support of statistical evidence, to have an INFLUENCE ON THE INTENSITY OF THE RISK in an insurance cover (i.e. impacting claim frequency and/or average claim size).

The risk factor may not be objectively measurable, e.g. driving ability.

Question 29

Define what is meant by a rating factor

Answer 29

A rating factor is a factor used to DETERMINE THE PREMIUM RATE for a policy, which is measurable in an objective way and relates to the intensity of the risk.

It must, therefore, be a risk factor or a proxy for a risk factor(s).

For example, one proxy for driving ability (amongst others) might be how long the policyholder has had their driver’s licence.

Question 30

investigations the company is likely to carry out in the first year after a new product launch to monitor profitability

Answer 30

• Quote volumes by month (gauge the marketing campaign success)
• Calculate and monitor the new business conversion rates (indication whether rates are competitive)
• Business volumes written against that expected (higher means rates are too low, lower means ineffective marketing / high rates)
• Reported claims experience
• Expenses incurred by writing the business and policy servicing
• Commissions by sales channel
• Premiums compared to competitors

Question 31

Discuss the importance of using sensitivity tests as part of the model parameterisation process.

Answer 31

The parameterisation process involves the setting of assumptions for the various cashflows/values/quantities in the model.

Sensitivity testing involves testing how sensitive the output of the model is to changes in each of the input parameters.

• This is important to know, because the company should put more time and effort into accurately determining the assumptions that have the biggest impact.
• This is because there is the potential for the best estimate parameters to be incorrect.
• The output would therefore be incorrect, potentially resulting in poor decisions being made by management, based on the model output.
• A key step up from senstivity testing to scenario modelling is that the assumptions are not changed in isolation, but any changes to one parameter are accompanied by consistent changes in other parameters in the model.

Question 32

Relative advantages of scenario tests using a deterministic model

Answer 32

Involves considering combinations of variables that could realistically occur at the same time, resulting in a given outcome.

• Experts can apply their minds to thinking of REASONABLE SCENARIOS.
• There will be CONSISTENCY BETWEEN CASHFLOWS because experts would have thought through the entire scenario carefully.
• There is more TRANSPARENCY with a stochastic model.

However, it may be difficult to attach probabilities (or return periods) to the scenarios.

Question 33

Relative advantages of scenario tests using a deterministic model

Answer 33

 Each simulation can be considered a generated scenario. The final result of each simulation can be broken down into cashflows, classes etc. contributing to the scenario.

 Generates MANY MORE SCENARIOS than could be generated manually.

 If correlations and relationships between variables are set accurately then the cashflows within the scenarios generated by the model will be consistent.

 The model may reveal severe scenarios that were not thought of previously.
— Even if these scenarios ultimately prove to be unrealistic, they will prompt investigation into these areas.

 Will generate a DISTRIBUTION OF OUTCOMES, so will be a smoother range of scenarios at different severity levels.

• – This is useful when communicating risk measures at different severity levels (confidence levels).
• – It is more difficult to understand what severity level the manually generated scenarios are (as mentioned above).

Question 34

Contingent capital arrangements

Answer 34

Contingent capital is based on a contractual commitment to provide capital to an insurer after a specific adverse event occurs that causes financial distress.

The insurer purchases an option to issue its securities at a predetermined price in the case that the defined situation occurs, on the understanding that the price would be much lower after such an event.

If the defined event occurs, leading to financial distress, the price of the insurer’s securities will fall. The option will allow the insurer to sell securities after the adverse event at a higher price than their market price.

Contingent capital provides a mechanism of ensuring that, should a particular risk event happen, capital will be provided.
As such, it is a cost-effective method of protecting the capital base of an insurance company. Under such an arrangement, capital would be provided as it was required following a deterioration of experience.

Question 35

Insurance-linked securities

Answer 35

The insurer issues a bond with interest payments and repayment of principle contingent on claims experience specified at the time of issue, i.e. if claims experience exceeds a specified level, this allows the insurer to reduce or cancel the bond repayments in a pre-specified manner.

Claims experience may relate to:

• the entire industry;
• specific parts of the insurer’s business
• catastrophic losses.

Question 36

Explain why traditional approaches such as the burning cost approach are not appropriate for modelling catastrophes.

Answer 36

Traditional rating approaches work well for high frequency, low severity risk.

However, they are much less appropriate for a low frequency, high severity risk.

This is because the observed losses may not reflect the true underlying risks, as the period over which losses have been observed may be much shorter than the return period of the losses under consideration.

The main actuarial assumption that is used when modelling high frequency, low severity risks is that the past is a reasonable guide to the future.
This assumption is not justifiable when it comes to events that are rare or uncertain in terms of either frequency or severity such as catastrophes.