Exams

Question 1

Define the term “free capital”

Answer 1

Free capital is the excess of available capital over required capital, on either a regulatory or
economic basis.
Available capital is the excess of the insurer’s financial resources (assets) over the value of
its liabilities (typically measured on a regulatory or economic balance sheet).

Question 2

Outline the key factors that should be taken into account in deciding on the allocation method
to be used for capital.

Answer 2

 The purpose of capital allocation e.g. to determine cost of capital by line of business
for performance measurement, pricing, or business and strategy planning.
 Desirable properties of results e.g. stability over time, understandable.
 Practical considerations e.g. Shapley method may be impractical if there are too
many classes (the number of scenarios needed is the factorial of the number of
classes).
 There may not be a single method that is suitable for all purposes.
 The final allocation may be based on judgement, for example the results from
several methods of allocation would be compared before deciding on the final
allocation.
 Consider what was done previously.

Question 3

Outline briefly the traditional steps involved in determining the expected claims cost used to
derive the risk premium (8)

Answer 3

 Collect relevant data, including past exposure data and claims arising from the
exposure.
 Adjust the data to make it more relevant e.g. if policy conditions have changed.
 Group data into risk groups (if there are significant differences between groups).
 Select the most appropriate rating model or estimation process for the specific case.
 Analyse the data (e.g. to pick up trends in the ratio of claims to exposure over time).
 Set assumptions required by the model or process.
 Test the assumptions for goodness of fit or likelihood probability.
 Run the model or process to arrive at an estimate of future claims costs.

Question 4

Define what is meant by “fraud risk”.

Answer 4

Fraud risk is the risk associated with intentional misappropriation of funds, undertaken with
the objective of personal benefit at the expense of the firm.

Question 5

Define the term “reinsurance to close”, describing how the process operates

Answer 5

An agreement under the Lloyd’s system of 3 year accounting. Underwriting members (the
reinsured members) for one year of account (the closing year) of a syndicate agree with
another party (the reinsuring party) that the reinsuring party will assume responsibility for
the handling and paying all known and unknown liabilities of the reinsured members arising
out of insurance business underwritten by the syndicate and allocated to the closing year.
The reinsuring party would usually be the subsequent open year of the same syndicate but
could also be a later open year, an open year of another syndicate or a reinsurer outside
Lloyd’s.
The term is also sometimes referred to as the premium paid to the reinsuring party by the
reinsured members for the above-mentioned transfer.

Question 6

Define the “chain ladder method” for reserving

Answer 6

A statistical method of estimating outstanding claims, whereby the weighted average of
past claims development is projected into the future. The projection is based on the ratios
of cumulative past claims, usually paid or incurred for successive years of development.

Question 7

funded (or three-year) accounting

Answer 7

• Funded (or underwriting year) accounting refers to the accounting for business by year written.
• For business written in a year the associated cashflows are paid to/from a ‘fund’ relating to that business for a number of years until the closure of that fund.
• At fund closure, the remaining liabilities are reinsured and assets remaining after the payment of the reinsurance to close premium are regarded as profit.
• “Three year accounting” refers to the practice of closing funds after three years.
• For longer tailed classes of business fund closure may occur beyond three years (e.g. four or five years).

Question 8

Benefits of property:

Answer 8

• The benefit is of indemnity type.
• The benefit will be the amount required to fully reinstate (including the clearing away of debris, rebuilding, repairing etc,) the property, rather than the market value of the property.
• This is usually less than the market value of the property, since the value of the land itself is not normally impaired by the destruction of the building.
• The benefit would be dependent on any limits, deductibles or excesses in place.
• The benefit is real in nature and will increase with inflation (which could be different from CPI as it could include building costs and workers’ wages).
• The benefit will likely be a lump sum payment but could be provided in instalments if a property needs to be rebuilt in stages.

Question 9

Explain what is meant by a “diagnostic”

Answer 9

A diagnostic is a measure used to assist with interpretation of data or results, and to help us verify underlying methodologies and assumptions.
Diagnostics can indicate that experience is inconsistent with the underlying assumptions. Some diagnostics are a test of results e.g., IBNR divided by premium and others test data e.g., paid claims divided by RBNS claims, and some test both e.g., ultimate loss ratios
Diagnostics can also be used to identify trends, perform comparisons over time or across different insurance classes or against benchmarks.