Past papers 2017

Question 1

Commutation

Answer 1

The process of PREMATURELY TERMINATING a reinsurance contract by
agreeing an amount to settle all current and future claims.

Question 2

Reinstatement premium

Answer 2

The premium paid to the reinsurer to RESTORE FULL COVER following a claim.

The number of reinstatements, and the terms upon which they are made (some will be free), will be agreed at the outset.

Applicable to: Non-proportional (XL) reinsurance

Question 3

Credit insurance

Answer 3

Covers a creditor against the risk that debtors will not pay their obligations.

Question 4

2 Types of Credit insurance

Answer 4

• trade credit

- mortgage indemnity

Question 5

Trade credit

Answer 5

May cover uncollectable debts.

Question 6

Mortgage indemnity

Answer 6

Covers the lender against the borrower defaulting and the value of the property on which the loan is secured not being sufficient to repay the loan.

Question 7

Creditor insurance

Answer 7

Provides cover to the insureds who are unable (usually due to disability and unemployment) to meet their obligations to repay credit advances or debt.

Most policies are issued to individuals to cover personal loans, mortgage loans or credit card debts.

The policy will pay the regular loan payments until the borrower is recovered or obtains new work or until the loan is fully repaid or a maximum number of repayments are made.

Question 8

NATURE OF THE LIABILITIES under creditor insurance

Answer 8

NATURE OF THE LIABILITIES
In most case, liabilities are fixed, e.g.:
- payments on personal loan policies will be the monthly repayment specified in the loan arrangement; such loans are usually at a fixed interest rate.
- payments on credit card policies are usually the minimum monthly payments on the balance prior to claiming.
- payments on mortgage policies are normally a set amount selected by the insured at policy inception, and linked to the monthly repayment.Occasionally the benefit may be variable and linked to interest rates. To the extent that interest rates reflect inflationary expectations, these benefit payments may be regarded as real in nature.

Question 9

Term of the liabilities under creditor insurance

Answer 9

Term of the liabilities:
There is usually a maximum number of benefit payments, and this will determine the maximum term of the liabilities. This could be several months or years.

Question 10

Currency of the liabilities under creditor insurance

Answer 10

Currency of the liabilities:

Benefits paid and premiums received will be in the currency of the country that the insurer operates in.

Question 11

Uncertainty of the liabilities under creditor insurance

Answer 11

Uncertainty of the liabilities:
This could be substantial as it depends on:
- Economic circumstances: Recessions leading to higher unemployment.
- Economic recessions leading to higher disability-related claims.
- Interest rates: if the benefit payment is linked to this, higher interest rates increase benefit amounts.
- Access to healthcare and medical advances: this could reduce disability recovery time and hence benefit payments.
- Moral hazard: Borrowers whose loans are covered by creditor insurance are incentivised to return to employment.

Question 12

Suitable matching assets for creditor insurance

Answer 12

• Government fixed interest bonds of a suitable term; these are highly liquid (hence suitable given the high level of uncertainty) and match fixed benefits.
• Corporate bonds offer enhanced returns, but this comes at a higher risk (default and liquidity)
• money market instruments (cash): this investment offers a link to inflation, and so might be suitable for liabilities linked to variable interest rates. Cash is the most liquid asset.

Question 13

Outline briefly 8 other key considerations in reviewing the investment strategy.
(beyond the characteristics of the liabilities)

Answer 13

• Free assets: the higher the free assets, the less matching is required which allows the company to pursue more aggressive strategies to enhance returns.
• Company risk appetite and any ethical or other voluntary restrictions.
• Tax, Legal and regulatory requirements
• Extent to which new business may be relied upon for cashflows, permitting existing assets to be invested longer
• Diversification permits higher return per unit of risk
• Existing assets - changing assets is costly, so consider the appropriateness of existing assets
• Level of non-investible funds influences the level of liquidity required from investible assets
• Economic outlook may influence some of the asset decisions
• Rating agency constraints on free assets required to maintain credit ratings.
• Competitor strategies might be useful as a benchmark (consider the risk of pursuing a different strategy).

Question 14

Why do adjustments need to be made to past reinsurance data when pricing?

Answer 14

We need to ensure that past experience is indicative of what may happen in the future period for which premium rates are being set.

Many different factors may cause the base experience to be different from that expected during the new rating period e.g.

• changes in risk and/or cover provided,
• environmental changes and
• general trends.

In each case, we will need to make a suitable adjustment to both the exposure and the claims data.

Question 15

6 Examples of time delays which could require adjustments to be made to past data

Answer 15

Time delays that may result in adjustments having to be made to the data may occur because of time taken:

• for sufficient claims experience to develop from the historical data;
• to analyse the claims experience;
• to reach and agree the new premium rates and premium structure;
• to administer and implement the new rates
• for any approval needed from a regulatory body to introduce rates
• due to communication delays between the insurer and reinsurer

Question 16

Changes in reinsurance risk over time may arise because of changes in (5)

Answer 16

• the mix of underlying risks
• cover / policy conditions
• claims handling / underwriting strategy
• the level of reinsurance cover
• the method of distribution

Question 17

3 Different ways of grouping claims cohorts for the purpose of projecting the claims run-off

Answer 17

• Accident year
• Reporting year
• Underwriting year

Question 18

Grouping by accident year

Answer 18

Claims are grouped according to the year (or other period / cohort) in which the claim event or “accident” occurred.

Question 19

Grouping by reporting year

Answer 19

Claims are grouped according to the year (or other period / cohort) in which they are reported to the insurer/reinsurer.

Question 20

Grouping by underwriting year

Answer 20

Claims are grouped according to the year (or other period / cohort) in which the policy covering the claim is incepted.

Question 21

Why is capital allocation desirable?

Answer 21

PERFORMANCE MEASUREMENT
Capital has a cost. Therefore, to accurately assess the performance of a particular class, we need to calculate the profit/return as a percentage of the capital required to write that class. i.e. a return on equity.
This requires knowing the capital cost for each class.

BUSINESS PLANNING AND STRATEGY SETTING
This links quite closely to the previous point. If the insurer can allocate capital to different areas of the business (and hence understand risk-adjusted performance) then it can make decisions about which areas of the business to develop based on return on capital. This can be extended when deciding on which new ventures/products/territories to pursue.

PRICING
Premiums charged should have a capital/profit loading to reflect the cost of capital held to write the business. The insurer will want to allocated capital to products of policies so that the premium rates can accurately take account of the risk of the product/policy.

Question 22

Describe the main drawback of the marginal capital method of allocation.

Answer 22

With the marginal capital method, we consider the ADDITIONAL CAPITAL that would need to be held if the element was to be added to the business.

This method will allocate a different level of capital to different classes of business depending on the order in which capital is allocated to the different classes. This is because a class of business will be correlated to other classes to different extents.

Therefore, the additional diversification benefit to be gained by “adding” another class of business to the portfolio will depend on which classes have been added so far.

Generally, classes of business added to the model later will receive a lower capital allocation as they benefit from diversification with classes already in the model. This is not fair on the classes modelled first as the diversification benefit would not be possible without them.

It is thus difficult to suggest that certain classes contribute more to the diversification benefit than others.

Question 23

How does the shapely method overcome the main drawback of the marginal capital method?

Answer 23

The Shapely method repeats the marginal allocation method, adding classes in all possible combinations of orderings.

The AVERAGE of capital requirements is then taken as the capital requirement for each class.

This results in the ordering not having an effect.

Question 24

Key considerations when modelling earthquake risk

Answer 24

• Earthquake risk can have a substantial cost on a property book, so the benefit of building a more detailed model will likely be worth the cost.
• The company will only be able to use its own data to a very limited extent as the nature of earthquakes is that they are rare events.
• The company will need to decide to what degree to rely on help from proprietary cat modelling companies, taking into account the cost and how specifically proprietary output is tailored to the company.
• If possible, the model should simulate claims from all classes of business that may be affected by the same earthquakes, e.g. an earthquake in a built-up area would damage a number of cars and residential buildings in addition to commercial buildings. The size of individual claims may not be significant, but the accumulated amount may be very high.

Question 25

Process for modelling earthquake risk

Answer 25

• The company will likely need to PURCHASE MODEL OUTPUT from an expert company.
• – which will include potential earthquake events and their associated locations, severities and frequencies.
• A SIMULATION MODEL would then be able to simulate whether each of the events happens or not in a particular year (single run of the model).
• The key modelling function is then to determine the cost to the insurer if each earthquake were to occur.
• – this will be a function of the amount of exposure the insurer has (measured in terms of EML) at or within a near range of the location of the simulated earthquakes.
• For particularly large buildings, the insurer may wish to model damage separately, rather than grouped by postal code.
• The reinsurance model should be able to calculate recoveries on the Cat XL treaty.
• For particularly large risks, it should also be possible to calculate recoveries on IXOL treaties.
• Key parameters should be sensitivity tested to understand model sensitivity to each factor and decide which factors are worth putting more time into estimating accurately, including more research.

Question 26

Factors to consider when deciding on how much free capital to hold

Answer 26

• Holding additional free capital will incur an extra cost and put pressure on the company to achieve more profits to achieve a given level of return on capital.
• The company will want to have a capital buffer above the minimum required level for the following reasons:
• – to reduce the risk that the available capital falls below the regulatory requirement, which would hamper the firm’s business activities.
• The company’s credit rating may depend on the solvency buffer.
• To maintain a level of working capital for investment in business development and other opportunities.
• To allow a buffer between the actual profitability of the business and the dividend stream paid to shareholders, who prefer less volatile returns.

Question 27

6 Ways in which an insurer could - in the near future - increase the ratio of available capital to the minimum capital requirement.

Answer 27

REINSURANCE.
Purchasing more reinsurance will reduce the capital requirement, but will likely incur an extra cost in the long run as the reinsurer will price in an expected profit.

SELL LESS BUSINESS
This will reduce the capital requirements due to a lower level of risk exposure taken on, but the company must be weary of having too low business levels to recover fixed expenses.

SAFER INVESTMENT STRATEGY
Following a matching strategy and limiting risky investments such as equities will reduce the investment contribution to capital.

CHOOSING ADMISSIBLE ASSETS
Not all assets will be allowed as assets on the capital balance sheet for regulatory purposes.

CURRENCY HEDGING.
As the company offers the product internationally, it will be exposed to the risk of the local currency depreciating relative to international currencies. It could consider having investments in foreign countries to match claim payouts.

CO-INSURANCE
This may be an option for sharing risk and reducing capital requirements, similar to reinsurance.

INCREASE PREMIUMS
This will have the effect of increasing expected profitability and shifting the profit distribution to the right, therefore reducing capital requirements.

PRODUCT DESIGN
The insurer can use certain product design features to limit the extent of risk taken on.