Professional Documents
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Subject ST2
CMP Upgrade 2012/13
CMP Upgrade This CMP Upgrade lists all significant changes to the Core Reading and the ActEd material since last year so that you can manually amend your 2012 study material to make it suitable for study for the 2013 exams. It includes replacement pages and additional pages where appropriate. Alternatively, you can buy a full replacement set of up-to-date Course Notes at a significantly reduced price if you have previously bought the full price Course Notes in this subject. Please see our 2013 Student Brochure for more details.
This CMP Upgrade contains: all changes to the Syllabus objectives and any significant changes to Core Reading. significant changes to the ActEd Course Notes, Series X Assignments and Question and Answer Bank that will make them suitable for study for the 2013 exams.
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1.1
The third set of bullet points of Syllabus Objective (b) (covered in Chapters 1 to 4) have also been updated. The last bullet has been shortened so that it now reads: and the products may be written on the following bases: single or regular premium without-profits non-linked unit-linked index-linked with-profits single, joint, or group life basis with or without options.
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Syllabus Objective (e) (covered in Chapters 8 and 9) has been updated. The fifth bullet has been shortened so that it now reads: (e) Describe the effect of the general business environment, including the impact on level of risk to the insurer, in terms of: propensity of consumers to purchase products methods of sale remuneration of sales channels types of expenses and commissions including influence of inflation economic environment legal environment regulatory constraints and opportunities fiscal constraints and opportunities professional guidance constraints and opportunities.
You should change the syllabus objective on Page 1 of Chapters 8 and 9 accordingly. Syllabus Objective (f) (covered in Chapters 10 to 12) has been updated. The 6th, 10th, 13th and 16th bullets have been shortened so that it now reads: (f) Discuss how the following can be a source of risk to a life insurance company: policy and other data mortality rates investment performance expenses, including the effect of inflation withdrawals mix of new business volume of new business guarantees and options competition actions of the board of directors actions of distributors failure of appropriate management systems and controls counterparties legal, regulatory, and fiscal developments fraud aggregation and concentration of risk.
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You should change the syllabus objective on Page 1 of Chapters 10 to 12 accordingly. Syllabus Objective (l) (covered in Chapters 22 and 23) has been updated. The first and second bullets have been shortened so that it now reads: (l) Describe methods of determination of discontinuance and alteration terms for without-profits contracts, and calculate the following benefits on the early termination or alteration of a contract: Calculate surrender values for conventional insurance contracts using reserves. Calculate paid-up sums assured for conventional insurance contracts using reserves. Use reserves to evaluate the financial effect of alterations to policies.
You should change the syllabus objective on Page 1 of Chapters 22 and 23 accordingly. Syllabus Objective (n) (covered in Chapters 18 and 19) has been updated so that it now reads: (n) Describe the principles of setting assumptions for pricing and valuing life insurance contracts, including profit requirements.
You should change the syllabus objective on Page 1 of Chapters 18 and 19 accordingly. Syllabus Objective (o) (covered in Chapters 20 and 21) has been updated. The third bullet has been amended so that it now reads: (o) Describe how supervisory reserves may be determined for a life insurance company in terms of: the principles of setting supervisory reserves the reasons why the assumptions used may be different from those used in pricing the calculation of non-unit reserves allowing for future bonuses on with-profits contracts the use of sensitivity analysis the interplay between the strength of the supervisory reserves and the level of solvency capital required.
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You should change the syllabus objective on Page 1 of Chapters 20 and 21 accordingly. Syllabus Objective (p) (covered in Chapter 29) has been updated so that it now reads: (p) Describe the principles of investment and how they apply to a life insurance company.
You should change the syllabus objective on Page 1 of Chapter 29 accordingly. Syllabus Objective (q) (covered in Chapter 31) has been updated so that it now reads: (q) Describe how the actual experience of a life insurance company should be monitored and assessed in terms of: the reasons for monitoring experience the data required the analysis of mortality, withdrawal, expense and investment experience the reasons for analysis of surplus and the reasons for analysis of embedded value profit the use of the results to revise the models used and assumptions.
1.2
Core Reading
Chapter 1 Section 3.2 The wording of the first paragraph should be amended to read:
The savings nature of the contract introduces a greater investment risk than for a term assurance, but the extent depends on whether the contract is unit-linked (and whether any guaranteed benefits are given), index-linked, without-profits or with-profits.
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Chapter 2 Section 2.2 The wording of the third paragraph has been extended to read:
With both types of contract there is a financial risk from withdrawals at times where the asset share is negative. The risk is exacerbated in the case of decreasing term assurances if the cost of benefit exceeds the premium being charged early in the term.
Section 2.3 The wording of the first paragraph has been amended to read:
The basic reserves for term assurance contracts are relatively small, but solvency capital requirements can be more significant in some jurisdictions.
Chapter 3 Section 1.3 The wording of the first paragraph has been amended to read (note that the last sentence of this paragraph has been deleted):
The contracts can give rise to significant capital requirements, depending on the relationship between the pricing and supervisory reserving bases and on the additional solvency capital requirements.
Chapter 4 Page 3 The wording of the first paragraph has been amended to read:
Typically, term assurances would be written only on a conventional without-profits basis. Whole life and endowment assurances are typically written on a unit-linked or with-profits basis, with new conventional withoutprofits business being rare. Annuities tend mainly to be written on a conventional without-profits basis, although are often also available on an indexlinked basis (and in some countries also on a with-profits basis).
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Chapter 5 Page 2 The wording of the final paragraph has been shortened to read:
The asset share is the accumulation of premiums less deductions associated with the contract, all accumulated at the actual rate of return earned on investments.
Page 3 There have been a number of additions and deletions to the bullet points so that they now read:
Deductions include all expenditure associated with the contract(s), in particular:
direct expenses incurred and any commissions paid the cost of providing all benefits in excess of asset share eg life cover or any other guarantees or options granted possibly on a smoothed, rather than current cost, basis tax (if appropriate) including any reserves made for future tax liabilities transfers of profit to shareholders the costs of any capital necessary to support contracts in the early years any contribution to the free assets which, in turn, support the smoothing of bonuses and the ability to exercise greater investment flexibility.
The following two paragraphs have been added after the bullet point list:
If other than asset share is paid out on average on surrender, then the calculation could also include addition of surrender profits (or deduction of losses) from with-profits business. A further potential addition to the asset share is an allocation of profits/losses on without-profits business, depending on the participation structure.
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Chapter 7 Section 3.2 The wording of the first paragraph has been amended to read:
A life insurance company is likely to have as one of its business objectives the maximisation of the profit distribution to policyholders so as to improve its competitive position. The actuary advising the company on its distribution of profit needs to balance this with other objectives.
Section 3.4 The wording of the first paragraph of Core Reading has been extended to read:
As mentioned in Section 3.1, the premium rates charged will contain margins designed to generate profit which will then be distributed to policyholders. The pace at which the profit arises and the pace at which it is distributed may or may not be the same. If part of the profit is deferred to some future date before being distributed then it may augment the companys free assets in the meantime and increase its ability to take on risk. Depending on the constitution of the company and the regulatory regime, surplus in respect of with-profits business may be available to support new business. Even in jurisdictions where reserves must be held for undistributed profit which is earmarked for future bonuses, it is generally the case that the overall reserves would be lower than had the profit been distributed.
Page 14 The following paragraph of Core Reading has been added after the seventh paragraph (ie just before the heading Additions to benefits):
As mentioned in Section 1.1 of Chapter 6, deferral of profit distribution also reduces the probability of insolvency.
Chapter 9 Page 2 The first two paragraphs have been amended to read:
A life insurance company will incur costs in running its business: commission payable to salespeople (unless the business is written on a fee basis) and management expenses.
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Initial commission may be payable on the acquisition of a new policy, with renewal commission payable each time a renewal premium is paid. If a policy lapses, part of the initial commission may be recoverable and there will be a risk of non-recovery.
Page 9 A new regulatory restriction has been added just below Question 9.9. The remaining restrictions need to be renumbered so that the old restriction 3. becomes the new restriction 4. and so on. The new Core Reading and ActEd example are as follows:
3. Restriction on rating factors that can be used to calculate premiums, for example gender or age.
Example The March 2011 European Court of Justice (ECJ) decision on an insurance opt-out provision from the EU Gender Directive is a good example of restrictions on rating factors. The insurance opt-out provision from the directive meant that, provided they met certain conditions, EU insurance companies were allowed to use gender as a premium rating factor. However, the ECJ ruled that this opt-out was not valid and should be removed, with the result that from December 2012 EU insurance companies are no longer able to use gender as a rating factor. Page 10 Restriction 5. has been renumbered as restriction 6. and amended to read:
6. Restrictions on the ability to underwrite, for example a prohibition on the use of the results of genetic testing, or prohibition of use of past claims history or medical history.
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Chapter 10 Page 4 A new paragraph has been added immediately after the heading for Section 1.1 as follows:
Having high quality policy data is vital for the good management of an insurance company.
Page 5 A new paragraph has been added immediately after the heading for Section 1.2 as follows:
Other data useful to actuarial investigations might include information on asset holdings and external data.
statistics or an overseas market. Page 7 The first bullet point has been extended to read:
a model risk that the model, typically a probability distribution, chosen to represent future mortality, etc, may not be appropriate or may contain errors;
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Page 12 The third paragraph of Core Reading has been amended to read:
There is, therefore, a risk that the charges accruing to the company in a year will not cover the actual expenses of the company in that year.
Chapter 11 Pages 12 to 14 Section 8 has been extended to include counterparties other than just reinsurers. The words in the long term have been deleted from Section 9. In Section 10, the second bullet has been extended and a new paragraph has been added at the end on money laundering. Replacement pages 11 to 14 are attached. Chapter 12 Page 3 The following paragraph has been added after the first paragraph:
Depending on the mix of products sold, the target market and investments held, the company may also be subject to concentration effects, both in terms of individual risks and overall types of risk.
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Page 6 The first paragraph of Core Reading has been amended to read:
The insurer will also wish to arrange its business practices and overall risk profile such that it minimises the possibility of being downgraded (or indeed leads to the credit rating being upgraded).
Chapter 15 Page 8 New material on the calibration of stochastic models has been added after page 8. Please insert the attached page 8A between your existing pages 8 and 9. Pages 11 to 13 There are a number of changes on these pages. Replacement pages are attached. Chapter 16 Page 2 The final paragraph has been amended to read:
For each model point, cashflows would be projected, allowing for reserving and solvency capital requirements, using a set of base values for the parameters in the model.
Page 3 The first paragraph of Core Reading has been amended to read:
The net projected cashflows will then be discounted at a rate of interest, the risk discount rate, which is discussed further in Chapter 18. It may, for example, take into account:
Page 11 The third paragraph of Core Reading has been amended to read:
For each model point, the present value of projected cashflows can be obtained as in Section 1.1. The discounting would be done using an appropriate risk discount rate, with similar considerations to those described in Chapter 18.
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Page 14 The final sentence of the third paragraph of Core Reading has been deleted so that it now reads:
Moving on to dynamic solvency testing, consideration needs to be given to the projection basis. The projections could be done deterministically using expected assumptions, combined with assumptions with margins to test the effect of adverse future experience.
Page 15 The fourth paragraph of Core Reading has been amended to read:
If future projected balance sheets themselves require stochastic calculations, this can present significant modelling challenges and might necessitate the use of approximations such as closed form solutions (eg the Black-Scholes formula).
Page 15 The first paragraph of Core Reading has been amended to read:
The fundamental reason why a life insurance company needs capital is so that it can withstand adverse, often unexpected, conditions. In turn, the amount of capital will be reflected in the companys ability to:
Page 20 The first two paragraphs (one Core Reading and one ActEd text) of Section 4.5 have been deleted. The next paragraph has been amended as follows:
Where a probability distribution can be assigned to a parameter, it may be possible to derive analytically the variance of the profit or return on capital. A sensitivity or scenario analysis can be carried out, such as at certain confidence intervals of the distribution. This again helps in assessing margins or in quantifying the effect of departures from the chosen parameter values when presenting the results of the model to the company.
Chapter 18 Page 9 A new section on market consistency has been added at the top of page 9. Replacement pages 9 and 10 are attached.
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The following paragraph has been added after the third paragraph:
The risk allowance is discussed further in the following section.
Page 26 A new section on market consistent valuation has been added at the bottom of page 26. Replacement pages 25 and 26 are attached. Chapter 19 Page 3 The first paragraph of Core Reading has been amended as follows:
The principles to be followed in preparing internal management accounts are matters to be discussed and agreed within the insurer. The aim is likely to be to produce expected values of the future experience, based on realistic assumptions.
Page 5 The second paragraph of Core Reading has been shortened as follows:
Here assumptions will be produced which are stripped of margins. The basis derived will be closer to that used for new business pricing.
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Chapter 20 Page 5 The word commission has been deleted from the second paragraph of Core Reading so that it now reads as follows:
The company should project forwards its non-unit cashflows (eg charges, expenses, benefits in excess of the unit fund) on the reserving basis. This may need to be performed on a policy-by-policy basis.
Pages 13 to 19 The section headed Zillmer adjustments has been deleted. Chapter 22 Page 3 The final sentence of the second paragraph of Core Reading has been extended as follows:
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(The non-payment of a surrender value for term assurances also helps with potential losses from the anti-selective effect of surrenders and allows cheaper premiums to be offered.)
Page 5 The second and eighth bullet points have been added to the list so that it now reads:
Surrender values should:
take into account policyholders reasonable expectations treat both surrendering and continuing policyholders equitably at early durations, not appear too low compared with premiums paid, taking into account any projections given at new business stage at later durations, be consistent with projected maturity values not exceed earned asset shares, in aggregate, over a reasonable time period take account of surrender values offered by competitors not be subject to frequent change, unless dictated by financial conditions not be subject to significant discontinuities by duration not be excessively complicated to calculate, taking into account the computing power available be capable of being documented clearly
The same two points have also been added to the list in the Summary. Page 12 The first three paragraphs have been amended as follows:
The retrospective value will represent the earned asset share at the date of surrender or an estimate thereof. Therefore, it would represent the maximum that the company could pay without making a loss. At early durations it should not look too unreasonable compared with the premiums paid. However, the retrospective method is likely to produce negative values (and hence zero surrender values) for regular premium contracts at very short durations, depending on the relationship between premium, initial expenses and commission.
So the asset share will only look reasonable (assuming its positive) if policyholders find the deduction for initial expenses acceptable.
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Page 20 The second paragraph under the heading of Expenses has been amended to read:
Allowance needs to be made for any renewal commission as paid.
Chapter 23 Page 6 The fourth bullet point has been extended as follows:
Any methods adopted should be stable in that small changes in benefits should result in small changes in premium, if expenses of alteration are ignored. In other words, an alteration method should ideally reproduce the existing terms if a policy is altered to itself (ignoring the impact of the cost of the alteration).
Chapter 31
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marketing expenses may be related to the amount of initial commission paid; underwriting expenses mainly related to the size of benefit.
The definition for fair value reserve has been amended to:
This is a reserve calculated using fair value accounting principles. A market consistent method of valuation, which has been increasing in importance in some countries, is an example of fair value reserving.
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The definition for regular reversionary bonus has been amended to:
This is a bonus that is declared on a regular basis, usually each year, throughout the lifetime of a with-profits contract. Once declared it becomes attached to the basic benefits and cannot generally be taken away.
The definition for risk premium reinsurance has been amended to:
In this method of reinsurance the direct writing company reinsures part of the sum assured or the sum at risk on the reinsurers premium basis. The sum at risk is the excess of the benefit payable over the valuation reserve.
The definition for solvency margin has been deleted. The definition for Zillmerisation has been deleted.
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Even so, the direct exposure of the insurance company to investment risk on unit-linked contracts is usually lower than for without-profits or with-profits contracts.
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Chapter 2 Section 2.3 The wording of the first ActEd paragraph has been amended to read: Even if we ignore the solvency capital requirements, the new business strain for term assurances may be significant. It is true that basic reserves tend to be small throughout the contract, but initial expenses can create initial capital strain on regular premium contracts, particularly if high levels of initial commission are paid. The high level of underwriting required for term assurances also causes high initial expenses. Indeed, as a percentage of premium income, the capital requirements on regular premium term assurance contracts can be large. Solution 2.2 (a) The first two paragraphs have been amended to read: The mortality risk is likely to be low, despite the fact that the policy was underwritten many years ago and the portfolio will include a mix of healthy and unhealthy lives. The reason is because the policy will have accumulated a large reserve by this point. Depending on the past rates of inflation that have been experienced, the sums assured may be relatively small in current terms anyway. There is the risk to the companys capital from the strain (loss) caused by a death claim, ie from the excess of the death benefit paid over the supervisory reserve held. The reserve will be large enough to cover the expected strain according to the mortality rates assumed in the reserving basis; only where the actual death strain is greater than this will the company have to provide additional finance. This risk should not be very large because the reserving mortality basis should be prudent. Solution 2.2 (b) The first paragraphs has been amended to read: As the policyholders have been recently underwritten, the probability of claiming is lower than in (a). However, the risk of making losses from higher than expected mortality remains high, because the sum assured is very large relative to the size of the reserve.
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Chapter 5 Summary The second set of bullet points has been amended to read: less expenses and any commissions, cost of all benefits in excess of asset share, tax, profit transfers to shareholders, cost of capital required to support new business strain, and any contribution to the free assets required to support smoothing of bonuses and increase investment freedom.
Chapter 7 Page 9 The wording of the first two ActEd paragraphs have been amended to read: For example, in both the US and the UK, allowance for differences in mortality at different ages is made in the with-profits premium rates. In the UK that is pretty much the end of the story. It would be unlikely that different bonuses would be paid to different age groups, even if, say, experience for older lives turned out significantly better than expected while that for younger lives was worse than expected. It would be treated as part of the pooling of risk. However, in this instance it would be quite likely in the US that a positive mortality contribution would be attributed to older lives and a negative one to younger lives. Chapter 9 Page 7 The example box has been deleted.
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Summary The third, sixth and seventh bullet points under the heading Regulatory regime have been amended to read: Governments may impose restrictions on life insurance companies, usually with the stated aim of protecting policyholders. The more common restrictions are: A restriction on the types of contract that a life insurance company can offer. Restrictions on the premium rates, or charges, for some types of contract. Restriction on rating factors that can be used to calculate premiums. Requirements relating to the terms and conditions of the contracts. Restrictions on the channels through which life insurance can be sold, on sales procedures or on information given at the point of sale. Restrictions on the ability to underwrite (eg prohibition of the use of genetic test results). An indirect constraint on the amount of business that may be written, via minimum reserving or solvency capital requirements. Restrictions on the types of asset or the amount of any particular asset in which the life company may invest for the purpose of demonstrating solvency.
Chapter 11 Summary The section on counterparties has been amended to read: Counterparties If an insurer has an agreement with another entity then it faces the risk that the entity either fully or partially defaults on their obligations or performs them to an unacceptable standard. This is counterparty risk.
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Chapter 15 Summary The following has been added just before the heading The financial economic approach: The parameters of a stochastic model can be set using either a risk neutral (marketconsistent) calibration or a real world calibration. The final paragraph under the heading The financial economic approach has been extended to read: Assessing the market value of other (non-financial) aspects of the liability (like mortality) is more problematic. There may be some actual market valuations of liabilities available eg for traded endowments. Alternatively a risk margin may be taken to reflect the inherent uncertainty in the non-financial assumptions. Chapter 18 Summary The following has been at the end of the summary: Market-consistent valuation If a market-consistent approach is used then the expected investment return can be set as the risk-free rate (regardless of the actual assets held). However, the investment return volatility and correlation assumptions depend on the actual assets held. A margin is likely to be included in the other parameter values to allow for the risk in their estimation.
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Should the effect of underwriting be allowed for in the basis for best estimate reserves? The following sentence (the final sentence of the third paragraph) has been deleted from the solution: So, without the effect of underwriting should be more strictly interpreted as meaning without the temporary initial selection effect or, simply, ultimate. Chapter 20 Pages 13 to 19 The section headed Zillmer adjustments has been deleted. solutions to questions 20.7 to 20.9 have also been deleted. Summary The section headed Use of a Zillmer adjustments has been deleted. Chapter 22 Page 8 The following paragraph has been added to the end of Section 2.4: Surrender scales should not contain discontinuities by duration to maintain equity between policyholders who surrender on either side of the discontinuity. For example, it would be unfair if the surrender value one week after a policy anniversary was significantly higher than for the week before the anniversary (after allowing for any premium paid on the anniversary). Chapter 30 Summary In the second set of bullet points under the heading Management of options the reference to strict interpretation of terms has been deleted, so that the list now reads: appropriate reserving using derivatives buy back from policyholder. The corresponding
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Chapter 31 Page 6 The following paragraph has been added just below the Core Reading bullet points: We would want to analyse the experience by the above factors even if we werent allowed to use them all in pricing. For example, if regulation does not permit the use of sex as a rating factor, we would still analyse male and female rates separately if possible in order to calculate the unisex rate that reflects our balance of male and female lives.
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5.1
Study material
We offer the following study material in Subject ST2: Mock Exam Additional Mock Pack ASET (ActEd Solutions with Exam Technique) and Mini-ASET Smart Revise Sound Revision Revision Notes Flashcards.
For further details on ActEds study materials, please refer to the 2013 Student Brochure, which is available from the ActEd website at www.ActEd.co.uk.
5.2
Tutorials
We offer the following tutorials in Subject ST2:
a set of Regular Tutorials (lasting three full days) a Block Tutorial (lasting three full days) a Revision Day (lasting one full day).
For further details on ActEds tutorials, please refer to our latest Tuition Bulletin, which is available from the ActEd website at www.ActEd.co.uk.
5.3
Marking
You can have your attempts at any of our assignments or mock exams marked by ActEd. When marking your scripts, we aim to provide specific advice to improve your chances of success in the exam and to return your scripts as quickly as possible. For further details on ActEds marking services, please refer to the 2013 Student Brochure, which is available from the ActEd website at www.ActEd.co.uk.
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All study material produced by ActEd is copyright and is sold for the exclusive use of the purchaser. The copyright is owned by Institute and Faculty Education Limited, a subsidiary of the Institute and Faculty of Actuaries.
Unless prior authority is granted by ActEd, you may not hire out, lend, give out, sell, store or transmit electronically or photocopy any part of the study material.
You must take care of your study material to ensure that it is not used or copied by anybody else.
Legal action will be taken if these terms are infringed. In addition, we may seek to take disciplinary action through the profession or through your employer.
These conditions remain in force after you have finished using the course.
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In other words the company has done all it can to put control systems in place and to act by them, yet there is always a finite risk that a mistake is made.
The failure of controls may result in:
It should be noted that control failures may, in particular instances, lead to financial gains for the insurer but nevertheless should be regarded as posing an ongoing risk.
You must be aware that there are two different levels of risk here. Consider the example of product pricing. When a price is fixed for a particular contract, there will be a risk that it is inadequate to generate the intended profit for the company. But in coming to decide on this price, the company will have gone through a decision-making process ie a control system. A company that fails to implement its control system properly may end up with a different price from that which should have been delivered by the system had it been correctly implemented. In most cases we would expect this error to leave the company in a financially worse situation (hence the three bullets of Core Reading listed above) but occasionally a management error can be fortuitously beneficial (hence the final part of the above Core Reading). Overall, though, the risk arising from the pricing process is increased by failures in of control. This also leads into the idea of optimal decision-making strategies (or control systems). In theory, ever more elaborate (and detailed) management control systems could be devised that lead to ever reduced risk for the company. Question 11.9 The optimal management control system is the one that leads to the smallest resulting risk. Comment on this statement.
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Counterparties
When a life insurance company enters into an agreement with another entity, it is relying on that entity to meet its obligations under the agreement. There is a risk that the entity will not be able to do this, and that they may either fully or partially default on their obligations or perform them to an unacceptable standard. This is counterparty risk. Examples could include:
reinsurance agreements (eg reinsurer default) outsourcing arrangements (eg poor quality service from a company providing outsourced administration services) corporate bonds held as investments (eg non-payment of coupons and/or capital by the issuing entity) distribution arrangements (eg non-recovery of broker balances).
We look at each of these examples in turn. Reinsurance is a process by which part of the liability under a contract is passed on to another insurer. Usually the full liability to the policyholder rests with the company that sold the business in the first place (the direct writer). If the reinsurer is unable to pay its share of a reinsured claim, then the direct writer faces a greater cost than expected. We discuss reinsurance in more detail in Chapters 25 and 26. Insurance companies often outsource functions such as IT, investment management and policy administration. Poor service from the company providing outsourced administration services could, for example, result in complaints from policyholders and costs for the insurance company to put things right. Insurance companies often invest in bonds or loans. The insurance company is then exposed to the possibility that the issuing entity (ie the entity that has issued the bond or borrowed through the loan) defaults on its repayments. This form of counterparty risk is often also referred to as credit risk. Often brokers collect the premiums and then pass them on to the insurance company, perhaps at the end of each month. The insurance company is then exposed to the risk that there is a delay in receiving these premiums, or that it never receives them at all.
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10
Fraud
A general type of control failure, caused by deliberate intent of one or more parties, is fraud. The main parties who might perpetrate fraud are as follows:
Directors or staff these parties will have special access to the financial (including banking) systems of the insurer and to the computer programs and data which support the business. Policyholders the main risk here relates to fraudulent claims, the risk increasing in proportion to the difficulty of detection. Countries with secure processes for certifying deaths represent reduced risks. There is also a risk to the insurer arising from criminal activities such as money laundering. Other outside parties such parties may effectively obtain some access to the computer systems of the insurer, particularly where there are external components such as website access.
Fraud that is perpetrated by policyholders is often alternatively called moral hazard. Money laundering is the process that criminals use to conceal the source of their assets. It is not unknown for criminals to attempt to buy insurance contracts with stolen money. They can then surrender the insurance contract to give the impression that their assets were from a legitimate source. Most countries require insurance companies to have strict controls in place to identify suspicious transactions which may be connected to criminal activity.
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Risk neutral (also known as market-consistent) calibration which in many countries is typically used for valuation purposes, particularly where there are options and guarantees. The focus of these calibrations is to replicate the market prices of actual financial instruments as closely as possible (see Section 3).
The first step in a market-consistent calibration is to choose a number of financial instruments (usually derivatives) that you know the price for. A model is then built that can project the cashflows from these instruments in a range of scenarios. The parameters are then chosen in such a way that the average present value of the cashflows from the modelled simulations is sufficiently close to the known market price. The idea is that if the model can closely reproduce the observed prices of quoted assets, then the model should also provide market-consistent values for unquoted asset or liability cashflows.
Real world calibration typically used for projecting into the future, for example for calculating the appropriate level of capital to hold to ensure solvency under extreme adverse future scenarios. The focus of these calibrations is to use assumptions which accord to realistic long-term expectations.
With the real world calibration we determine the model parameters using our expectations of the future. These assumptions are then used to project the values of the assets and liabilities under each stochastic scenario. To see the difference between the two calibrations, consider two investments: bonds with a market price of 100 and equities with a market price of 100. If we used the risk neutral calibration, then the average present value of the cashflows from our models simulations would be 100 for each investment, ie the model has replicated the observed market prices. However, if instead we used the real world calibration, we would expect that on average the simulated cashflows from the equities would be higher than the bonds (as this is what usually happens in real life).
All study material produced by ActEd is copyright and is sold for the exclusive use of the purchaser. The copyright is owned by Institute and Faculty Education Limited, a subsidiary of the Institute and Faculty of Actuaries.
Unless prior authority is granted by ActEd, you may not hire out, lend, give out, sell, store or transmit electronically or photocopy any part of the study material.
You must take care of your study material to ensure that it is not used or copied by anybody else.
Legal action will be taken if these terms are infringed. In addition, we may seek to take disciplinary action through the profession or through your employer.
These conditions remain in force after you have finished using the course.
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This also means that, for a market-consistent valuation of an insurers balance sheet, the
assets would be valued at market value.
In theory, a market-consistent value of a liability is the price that someone would charge for taking responsibility for (ie ownership of) the liability, in a market in which such liabilities are freely traded. In the usual absence of such a market, an approximate approach has to be taken. To value a liability, the financial economic approach will seek to set the results of cashflow projections so as to be consistent with market values, where a corresponding market exists.
For example, the expected cashflows on an immediate annuity, allowing for mortality, could be projected. A financial economic approach might be to place a market consistent value on the immediate annuity by valuing the cashflows as the maturity proceeds of a series of zero coupon risk-free bonds of matching terms.
One way of calculating the value of the liability is then to work out the current total price of the assets (the zero coupon bonds) that need to be bought in order to generate these cashflows exactly. (That is, we devise a portfolio of assets whose cashflows exactly replicate those of the liabilities, and then the current market price of this replicating portfolio becomes the market-consistent value of the liabilities.) Equivalently, we could produce the (same) market-consistent valuation by discounting the cashflows at current risk-free rates of interest.
The appropriate discount rate to obtain a market-consistent valuation would be the market yield on such bonds, ie a risk-free interest rate.
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We would actually use different discount rates for cashflows at different durations, if this were necessary to reflect current market yields. This means that the two approaches must result in the same answer. The above approach (using either alternative) is strictly only appropriate for cashflows that are of known and certain amounts. Question 15.4 So why will the above approach not actually give the correct market-consistent value for the immediate annuity liabilities using the method just described? With uncertain cashflows, the approach is to project their expected future amounts and then discount these as if they were known and certain, according to the above principles. So, in the case of the immediate annuity cashflows, we would first need to multiply the future annuity payments by some assumed survival probabilities, ie using an appropriate mortality assumption.
It may be difficult to obtain a market-consistent assumption for some elements of the basis, such as mortality, persistency or expenses.
In some cases, however, it may be possible to use some market-consistent indicators for setting the assumptions. For example:
the expense assumption could, for example, be determined by reference to expense agreements available in the market, eg from third party administration companies
the difference between the current market yields of equivalent fixed-interest and index-linked bonds gives an indication of the markets expectation for future inflation with-profit endowment assurances may be traded as investment vehicles, so there may be a current market price for these products as a whole.
(For the immediate annuity case, the first two examples would be relevant.)
As there is unlikely to be a highly liquid active market for mortality risk, the assumption may be set using industry statistics as a starting point.
Question 15.5 If we projected cashflows using best-estimate assumptions for these variables, the value we would obtain for the liabilities would not be correct. Explain whether the value obtained would be higher or lower than the actual market-consistent value.
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It is likely that a risk margin would be included in such assumptions due to the inherent uncertainty. This risk margin would reflect the compensation required by the market in return for taking on those uncertain aspects of the liability cashflows.
To allow for the uncertainty, we would therefore need to include appropriate margins into all the assumptions we need to make. The subject of risk margins in future assumptions will be fully explored in Chapters 16, 18 and 19 of the course. Question 15.6 Again for the immediate annuity example, should we use (appropriately) higher or lower mortality rates than best estimate in order to produce a market-consistent valuation? For any particular portfolio of liabilities we wish to value in this way, we would need to follow a similar procedure. Question 15.7 So far we have only considered the basic benefit outgo in the cashflows we need to value. List the other cashflows that may need to be projected, for any (without-profits) life insurance contract, in order to perform a market-consistent valuation of the liabilities.
A market-consistent approach is becoming widely accepted in some countries, particularly for the valuation of liabilities and assessment of the profitability of existing business. Even when not used as the primary methodology, the financial economic approach should be a useful tool in ensuring that the results from traditional approaches are reasonable and for ensuring that any risk margin in future assumptions is justified.
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Market consistency
If a market-consistent approach (as described in Section 3 of Chapter 15) is used, either deterministically or stochastically, then the expected investment return can be set as the risk-free rate, irrespective of the actual underlying assets held (this is the risk neutral calibration approach).
So if we are pricing an immediate annuity, we could use a deterministic model to obtain a market-consistent value by discounting using the risk-free rate appropriate to the term of each cashflow. The actual assets we intend to hold are irrelevant.
However, if the stochastic approach is adopted, then the investment return volatility and correlation assumptions do remain dependent on the actual underlying asset type(s).
So if we are pricing a maturity guarantee on a unit-linked fund, we could use a stochastic model to obtain a market-consistent value. We would calibrate the expected investment return to the risk-free rate, but would calibrate the volatility and correlation assumptions to the assets backing the unit fund.
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1.3
The actuary will want to reflect the incidence of the following marginal expenses:
initial acquisition (eg initial commission and related sales costs) initial medical underwriting initial administration renewal administration renewal reward to sales channel (ie renewal commission, or similar) investment withdrawal / paid-up expenses claim / maturity administration (often known as termination expenses).
The expense loadings should also contain some contribution to the companys fixed overheads. These will be any expenses not covered in the above marginal categories, but the distinction between marginal and fixed is subjective. For instance the property costs of the new business admin department could be considered as part of the marginal initial administration expenses, or as part of overall fixed expenses. Usually there would be no loading for the administration of withdrawals or policies becoming paid-up; instead, the cost would be allowed for in setting the appropriate discontinuance terms.
The values will be determined after analysing the companys recent experience for the type of business concerned. The result of this analysis will be a division of the expenses by function, as appropriate, and possibly by whether the level of expense is expected to be proportional to the level of premium or benefit, or can be expressed as an amount per contract.
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Of course, as the projects develop and lead to actual profits (or losses) then the nature of the riskiness of the company as a whole could change, thereby changing Ei . This is not inconsistent with our methodology, as the change in Ei will also reflect the changing mix of risk discount rates that we have used for pricing the individual projects themselves. Also, if Ei has not changed much since the last time a product was priced (or repriced), and the product concerned has not changed its risk profile fundamentally, then it would be logical to use the same risk discount rate as was used before for pricing (or repricing) the product. So, it should be possible to take the most recently used risk discount rate for a product, and then adjust it as necessary to reflect changes to the statistical riskiness of the product, to the overall required market return Ei , or to both. Question 18.17 Describe how you could determine a risk discount rate that reflects the expected level of statistical risk, for a given new product. Both of the following should be incorporated in your method:
You can assume that the shareholders required return on capital is known.
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In reality, the assessment of the risk, and the conversion of that into a risk discount rate, is a very inexact science. The most important points to remember are that:
The risk discount rate must be higher than the risk-free rate, hence changes in market rates of interest should cause risk discount rates to change. The margin between the risk-free rate and the risk discount rate should attempt to reflect all sources of risk in the product. The risk discount rates used for pricing different products should reflect the relative risk of those products. The overall return earned on the whole capital of the company, generated from its entire business activities, needs to meet the required rate of return (cost of capital). The risk discount rate is simply a number that is used as a criterion in profit testing. It is set to ensure that the rate of return from the product is satisfactory, given the inherent variability of the return and the required return on capital.
Profit criteria
It is necessary to decide on the profit criteria that need to be met by the price charged for a product, given all of the preceding assumptions. These have already been discussed in Chapter 16, but you should bear in mind that the chosen profit criterion is one of the assumptions that defines a particular pricing basis.
For example, you may recall from Subject CA1 that Solvency II calculates a risk margin using the cost of capital approach. Further details are not required for Subject ST2, but we will cover this in more detail in Subject SA2.