Past papers 2016

Question 1

Explain the effect that inadequate data could have on the insurer in terms of pricing and business acquisition.

Answer 1

When pricing, it is important that we monitor the progress of existing experience as it develops, in order to assess the need for a review. Thus one effect of inadequate data is that we might make a WRONG DECISION on the need for a review and rate to be charged.

When we carry out the actual projections of the new rating requirements, inadequate data may distort the calculations. This may be due to errors in:

• the apparent SIZE OF THE BUSINESS IN FORCE, and its value expressed in exposure units and premium
• the apparent CLAIMS EXPERIENCE and its trends, on which the projected future costs are being based.

Moreover, the errors may distort the true distribution of the business between risk groups. This could have consequences if we decided to adopt a differential rating increase for each risk group. It could also affect the marketing strategy if certain risk groups appeared to be more attractive risks than they actually are.

If we adopt a deficient set of rates as a result of faulty data, the insurer might:

• suffer UNDERWRITING LOSSES if rates are too low
• suffer LOSS OF MARKET SHARE if rates are too high
• attract UNDESIRABLE RISKS, causing deterioration in underwriting experience if rates for such risks are too low.

Question 2

Outline the measures a company could take to mitigate the effects of using inadequate data or poor quality data

Answer 2

• Take a PRUDENT VIEW of future experience and reflect this in the pricing structure.
• Consider writing only a SUBSET of risks/perils until actual experience becomes available.
• Consider only accepting liability covers with low limits and exposures until actual experience becomes available.
• Use more REINSURANCE, reducing the retention to reduce risk.
• Examine the SENSITIVITY OF PRICING MODELS to assumptions, particularly looking at whether it drives a decision on whether to write business or not.
• Carry out a “WHAT IF” ANALYSIS of a draft rating structure and set of decline rules to see what business would be won at what price comparing output from pricing models to the price charged by other insurers in the market.
• Put in place MONITORING OF KEY STATISTICS, such as volumes, premiums, mix of business and cause of claims to spot possible problems early.
• Ensure the company can change rates quickly with renewals every 6 months instead of annual renewals.
• Consider not selling insurance policies until better quality data is available to price.

Question 3

Economic capital

Answer 3

Economic capital is the value of the reserves that a company determines as appropriate given its assets, liabilities and business objectives.

It takes into account the riskiness of the individual assets, liabilities, correlations between these risks and the overall level of credit deterioration the company wishes to be able to withstand.

Question 4

XL Treaties

Answer 4

Protect the insurer against large individual accident losses as well as catastrophes that may lead to an accumulation of losses from a single event.

Question 5

What will the actuary need to do in order to understand the impact of an increase in the XL retention limit on the capital requirements?

Answer 5

The actuary will need to investigate the additional volatility caused by the proposed increased retention.

This can be done by:

• Analysing the VOLATILITY IN FREQUENCY AND SEVERITY of large individual historic losses suffered by the insurer. This can be done using several years’ past data. Historic losses will be inflated and projected to ultimate.
• Analysing the FREQUENCY AND SEVERITY distributions of accumulation type events, including natural catastrophes such as hail and storm.

Question 6

3 Types of investigation that an actuarial team could undertake to assess the company in formulating an optimal reinsurance structure

Answer 6

• Expected impact on profit, e.g. reinsurance premium payable vs expected recoveries.
• Analysis of alternate structures for reinsurance
• Analysis of reinsurance commission structures, overriders and profit commission.

Question 7

Perils covered by construction and engineering policies

Answer 7

• Damage to the project
• Destruction
• Design defects
• Discovery of construction faults
• Faulty parts
• Failure to finish the project, or finish on time

Question 8

Moral hazard

Answer 8

Moral hazard is the risk that an insured may behave in a less risk-averse manner when they are insured.

Question 9

define a “working layer”

Answer 9

Excess of loss reinsurance indemnifies the cedant for the amount of a loss above a stated excess point, usually up to an upper limit.

A WORKING LAYER is a layer of excess of loss reinsurance where the excess point is at a low enough level for it to be likely to experience a fairly regular flow of claims.

Question 10

type(s) of reinsurance commission which may be paid to a direct writer in respect of Excess of Loss reinsurance

Answer 10

PROFIT COMMISSION is the only type of reinsurance commission likely to be payable (if any).

This is commission which is dependent upon the profitability or claims experience of the business cede during each accounting period.

Profit commission may be payable for a working layer because the

• EXPERIENCE in a working layer is LESS RANDOM than for higher layers and is
• more LIKELY TO BE REPRESENTATIVE of the underlying risk.

Question 11

Define stability clause

Answer 11

A clause that may be included in a non-proportional reinsurance treaty,
providing for the INDEXATION OF MONETARY LIMITS (that is, the excess point and/or the upper limit) in line with a specified index of inflation.

It is designed to MAINTAIN THE REAL MONETARY VALUE of the excess point and the upper limit under non-proportional reinsurance.

Question 12

The impact of a stability clause

Answer 12

Depends on the cedant’s actual claims experience and on the inflation in claims relative to the specified index and also the excess point and upper limit.

If there was not upper limit and actual claims inflation was lower than the index inflation, then the frequency of losses to the layer would drop over time.

If claims inflation is the same as that used on the specified index, then the expected real cost of claims will remain constant.

Question 13

Define deductible

Answer 13

A deductable is the amount which, in accordance with the terms of the policy, is deducted from the claim amount that would otherwise have been payable and will therefore be borne by the cedant.

Question 14

Define aggregate deductible

Answer 14

The maximum amount that the cedant can retain within its deductible when all losses are aggregated.

Introdution of an aggregate deductible means that the sum of the claims to the layer must exceed the deductible before the cedant can make a recovery.
So, for a given amount of exposure, we expect the aggregate deductible to reduce the cedant’s expected recovery and increase the cedant’s retention.

Question 15

Define ranking deductible

Answer 15

Applies to each individual loss.

Ranking deductibles contribute towards an insured’s aggregate deductible. Non-ranking deductibles and trailing deductibles do not contribute to the aggregate deductible.

Question 16

Per-occurrence limit

Answer 16

The maximum amount that the insurer can retain for each individual loss.

Introduction of a per occurrence limit means there is a maximum potential loss on each claim and hence adding a per occurrence limit would reduce the expected cost of claims.

Question 17

4 Steps to estimate the next 3 years’ reinsurance risk premium under different reinsurance structures using a frequency-severity simulation model.

Answer 17

1. Determine the claim frequency and severity distributions
2. Determine exposures for the next 3 years
3. Simulation for a specific reinsurance structure.
4. Repeat step 3 for different reinsurance structures

Question 18

Estimate the next 3 years’ reinsurance risk premium under different reinsurance structures using a frequency-severity simulation model.

Step 1: Determine the claim frequency and severity distributions

Answer 18

Use the companies claim database, check data for completeness and correct any obvious data anomalies.

Pick a base period to use, e.g. last 5 years.

If there are any policy limits on the claims, an estimate of the number (an amount for each claim) needs to be estimated for those below the insured’s retention and those above the policy limit.

Use standard reserving techniques (chain ladder / BF) to calculate the number of IBNR claims and their cost. For a frequency-severity approach, we need to know the individual claim sizes and period in which the claim occurred. It is important to apply a development pattern that is appropriate for the losses being developed.

All claims from past years (including IBNR) need to be developed to ultimate and treated “as-if” they occurred in the following period. Consider appropriate assumptions to adjust for claims inflation, changes in policy wording / risks covered.

A decision regarding large and catastrophe claims needs to be made. Large claims and catastrophe claims are normally modelled separately.

Fit frequency and severity distributions to the losses, e.g.:

• FREQUENCY: Poisson, Negative Binomial
• SEVERITY: LogNormal, Weibull, Pareto, Gamma.

Apply STATISTICAL TESTS to determine the goodness of fit, e.g. Chi-squared Test or Kolmogorov-Smirnov statistic.

If there is sufficient volume of losses, consider fitting a number of different distributions to different parts of the overall loss range.

Question 19

Estimate the next 3 years’ reinsurance risk premium under different reinsurance structures using a frequency-severity simulation model.

Step 2: Determine exposures for the next 3 years

Answer 19

Using the company’s database with exposures, assumptions regarding for new business numbers over the next 3 years can be determined.

Question 20

Estimate the next 3 years’ reinsurance risk premium under different reinsurance structures using a frequency-severity simulation model.

Step 3: Simulation for a specific reinsurance structure

Answer 20

• Simulate Claims experience in each year based on exposures for each year.
• Re-run simulation a number of times. Each simulation will produce its own estimate of the number of claims and a corresponding set of claim amounts.
• For each simulation, apply excesses, limits and deductibles to determine total reinsurance.
• The average reinsurance recovery over all simulations in a particular year plus a loading for catastrophe and large claims would give an estimate for the reinsurance risk premium.

Question 21

4 potential challenges faced in comparing claims development patterns between two different agents writing the same class of business.

Answer 21

 The agents may use different definitions of when a claim is first recorded, e.g.
when first notified or when all supporting evidence has been provided.

 One agent may remove claims from its monthly listing if it settles as null, where the other may keep the claim on the listing with a zero amount.

 The agents may have different approaches to setting CASE RESERVES, e.g. one might put a conservative/full reserve on notification, whereas the other may put a token or zero reserve until investigations have been completed.

 They will have different processes for SETTLING A CLAIM, so the speed of paid settlement will vary between agents.

 Whilst both agents write the same class of business, they may operate in DIFFERENT GEOGRAPHICAL MARKETS and sell to different TARGET MARKETS.

 Each agent may use DIFFERENT SALES CHANNELS resulting in a different mix of underlying risk with different development patterns.

Question 22

ADVANTAGES of using a stochastic ALM relative to a

deterministic approach for the purpose of setting investment strategy.

Answer 22

A stochastic model is better for considering a BIGGER SET OF POSSIBLE SCENARIOS (usually several thousand) while a deterministic ALM can only practically consider a few scenarios.

The scenarios in the stochastic model are chosen randomly and therefore not subject to the modeller’s potential biases and limited perspective.

A stochastic model’s outputs incorporate probabilities (thus the likelihood of unfavourable outcomes associated with particular investment strategies), while the output from a deterministic model does not.

Both stochastic and deterministic ALMs can allow for suitable interaction between assets and liabilities, so this in itself is not a difference.

Risk-based solvency regimes like SAM and Solvency II require a better understanding of risks (including investment risks) faced by the company, which are better modelled by a stochastic ALM.

Question 23

DISADVANTAGES of using a stochastic ALM relative to a

deterministic approach for the purpose of setting investment strategy.

Answer 23

Stochastic models may have higher MODEL RISK (due to greater complexity) and introduce spurious accuracy in the modelling.

Practical difficulties are greater for stochastic models:
 Stochastic models are more DIFFICULT (requiring expertise) TO BUILD, CALIBRATE AND RUN.
 They REQUIRE MORE DATA than deterministic models.
 More COSTLY TO OBTAIN (build or purchase) and to maintain.
 The output may be more DIFFICULT TO INTERPRET.
 More time consuming to run.

Question 24

Explain the purpose of an ESG within an ALM exercise

Answer 24

An ESG typically takes the form of a specialised asset model that stochastically models various asset classes.

The output from an ESG includes the performance of each economic variable (e.g. inflation, asset class returns, GDP etc.) at each future projection point for several simulations.

This table of simulation outputs will be used as an input for the ALM

Question 25

The investment characteristics of employers’ liability liabilities

Answer 25

 Liabilities are INFLATION-LINKED (and expected to increase faster than CPI as they are related to loss of earnings, medical costs and judicial inflation, all of which are expected to increase faster than CPI).

 LONG TERM (for serious disability and death claims) and SHORT TO MEDIUM TERM (for more common injury and property damage claims). Overall liabilities should be considered long term as the largest claim liabilities would tend to be longer tailed.

 Quite POSSIBLE MULTI-CURRENCY, with many large employers now operating in various geographies.

 CONSIDERABLE UNCERTAINTY of ultimate settled claim amounts and timing.

Question 26

matched investment position for employers’ liability liabilities

Answer 26

 EQUITIES: returns are expected to be higher than CPI inflation over long terms, thus matching the nature and term of liabilities.

 INDEX-LINKED BONDS of suitable term: provide CPI-linked returns, thus provide a partial match for expenses and liabilities (particularly shorter term liabilities).

 CONVENTIONAL bonds: these might be suitable for shorter/medium term liabilities: actual inflation is unlikely to be far different from expected inflation over shorter terms.

 Cash might be suitable for shorter term liabilities: provides liquidity (suitable for liability uncertainty) and returns are broadly in line with CPI.

Question 27

2 Main types of capital

Answer 27

• Economic capital

- Solvency capital

Question 28

Solvency capital

Answer 28

The additional amount that a provider is required to hold in excess of its best-estimate provisions in respect of its liabilities.

Question 29

Economic capital

Answer 29

The amount of capital that a provider determines is appropriate to hold
given its assets, its liabilities, and its business objectives.

It is based on the riskiness of the firms assets, liabilities, the correlation of these risks and the overall level of credit deterioration the provider wishes to be able to withstand.

Question 30

Outline how the calculation of the types of required capital may differ

Answer 30

Economic capital is typically calculated using an insurer’s own INTERNAL MODEL, whilst regulatory capital would usually be calculated using a prescribed model or formula.

Economic capital would use a DETAILED BREAKDOWN OF ASSETS and risk exposures, using an insurer’s own risk profile, whereas regulatory capital would use data which are summarised to a degree, and applying market risk profiles/characteristics.

The economic capital requirement may be on a MORE REALISTIC BASIS, without any prudence which may exist on a regulatory basis. Even a regulatory basis which is on a best estimate basis may include a risk margin which represents an adjustment for uncertainty.

Economic capital may use a HIGHER LEVEL OF CONFIDENCE than the regulatory figure, especially if this is a published risk disclosure (or is used to achieve a higher credit
rating).

Risks and events may be correlated in a very complex manner in an economic capital setting, whilst this is normally more simply applied in a regulatory setting.

Question 31

Explain why the insurer might choose to hold additional capital above its solvency needs.

Answer 31

An insurer would reduce the risk that the available capital falls below the regulatory requirement, which would hamper the firm’s business activities. For example, an insurer who held only marginally more capital than the regulatory minimum would be exposed to the risk that a fall in asset values or a large claim would result in it being declared insolvent on a regulatory basis.

A GREATER DEGREE OF SECURITY is achieved by policyholders than implied by the relatively weak regulatory minimum. This may not be as important as the investor’s perceptions of security.

A firm with a higher degree of solvency will be more able to MAINTAIN ITS CREDIT RATING.
Credit rating models will be different from regulatory models and as such firms will be less certain of maintaining a certain credit rating than simply remaining solvent.

To meet the requirements of OTHER STAKEHOLDERS such as debt providers, whose interests may be subordinated to those of the policyholders. The regulator would not require regulatory liabilities to include amounts owed to subordinated debt holders because this will not affect the ability of the insurer to pay policyholders (as they are paid before subordinated parties). Nevertheless, the insurer will want to meet all of its liabilities.

To maintain a level of WORKING CAPITAL for investment in business development and other opportunities. This needs to be balanced with holding too much capital which shareholders may not accept.

An insurance company which is capital flush can afford to allow for a BUFFER BETWEEN THE ACTUAL PROFITABILITY of the business and the dividend stream paid to shareholders, who prefer less volatile returns.

Question 32

It has been suggested as a starting point for the inputs to the model that you use the figures provided in the company’s (optimistic) business plan.

Outline the ADJUSTMENTS which may need to be made to these figures to correctly parameterise gross underwriting risk in the internal capital model.

Answer 32

The overarching principle is that the adjustments to the business plan should serve to make the parameters of the model AS REALISTIC AS POSSIBLE, in order for the bias in the assumptions made to be removed.

The position in the UNDERWRITING CYCLE should be considered as this may cause assumptions to be inadequate given the current economic conditions which cannot be expected to change significantly over one year.

This may affect both the adequacy of premiums as well as claims ratios.

Premium adequacy can be adjusted through the use of an historical rate index, whilst claims ratios can be adjusted through the use of credibility techniques.

Past business plan accuracy may be considered as a way to justify any departure from business plan assumptions, in order to explain the difference between the best estimate model result and the business plan result.

The volume of business will need to be adjusted to reflect the most likely growth expected given past experience.

ALLOWANCES will have to be made in the business plan for LARGE AND CATASTROPHIC LOSSES, which may not be allowed for in the business plan.

Expense splits between direct and indirect expenses may need to be introduced into the internal model in order to correctly allow for the impact of new business on direct expenses, where these are not allowed for in the business plan. Commission should already be split out.

Expense reductions should be allowed for where these savings have been adequately explained and justified.

Question 33

Discuss the considerations which should be taken into account when deciding on whether or not and insurer should CEASE USING BROKERS.

Answer 33

All of the existing large policies are likely to be provided through brokers, thus it would be unwise to DISTURB EXISTING BUSINESS. If anything, only new policies should be pushed through the direct channel. Though, this should probably not be forced as it may result in the company losing new business that is presented to the company by brokers, as they will simply move to a competitor rather than proceeding to work through the direct sales method.

Even if the move is only for new business, when existing brokers hear about the move they may feel unfairly treated and decide to take their existing business elsewhere, resulting in a large loss of business for the company, particularly as these are the larger policies. This could result in a reputational risk.

The larger unusual products will likely require a fair level of EXPERTISE from the brokers.
Alternatively, the insurer can train its own staff, though this will be costly and less flexible. Flexibility is important as the company regularly takes on different types of business.

The direct sales method will be mostly fixed cost, though potentially with a small commission component, while brokers are paid purely by commission. Broker commission can be substantial on larger policies as it is usually expressed as a percentage.
It is thus possible that the direct sales unit can be run at a LOWER COST. Furthermore, as the
direct marketing channel is already established for personal lines business, an expansion of the unit should be less expensive than establishing a unit from scratch.

Brokers ACT IN THE INTEREST OF POLICYHOLDERS and are inclined to shop around for the best deal. While direct sales units act on behalf of the insurer. Thus, the broker method is likely to be more competitive, potentially resulting in premiums needing to be lower and hence lower profit.

However, on the flip side, brokers may present more business to the company as brokers are generally more proactive in seeking business due to the commission incentive. With unusual products, the markets may not be all that structured, making an effective direct marketing campaign tricky. It may be safer to rely on brokers to search for business.

An important consideration is how profitable the broker business has been. If it has been less profitable then it may be worth the risk of implementing the change as there is less to lose if they end up losing market share or something else goes wrong.