Past papers 2016 Flashcards

Question

The investment characteristics of employers’ liability liabilities

Answer 1

 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.

Answer 2

 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.

Answer 3

- Economic capital | - Solvency capital

Answer 4

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

Answer 5

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.

Answer 6

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.

Answer 7

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.

Answer 8

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.

Answer 9

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.