F102

Question 1

Define an endowment assurance.

Answer 1

An endowment assurance is a contract to pay a benefit on survival to a known date. The contract may also provide a significant benefit on the death of the life insured before that date. This cover is provided in exchange for either a single premium at the start of the contract or a series of regular premiums throughout the contract.

Question 2

Define the asset share of a contract.

Answer 2

The asset share is the retrospective accumulation of past premiums, less expenses and the cost of cover, at the actual rate of return on the assets.

In the case of with-profit contracts, allowance may be made for miscellaneous profits from without-profit contracts and from surrenders and lapses, and also for the cost of guarantees and any capital support provided.

In simpler terms, the asset share is the accumulation of monies in less monies out, the accumulated cashflow in respect of a policy.

Question 3

State the the components which give rise to deductions for an asset share of a contract. (P BEC TW)

Answer 3

commission paid and expenses incurred (net of tax, if appropriate)

the cost of providing all benefits in excess of the asset share (life cover, guarantees, options) on a smoothed, rather than current cost, basis

tax on investment income including any reserves made for future tax liabilities

transfers of profit to shareholders

the cost of capital necessary to support contracts in the early years

contributions to the undistributed surplus in the with-profits policyholder fund

Question 4

The capital requirement of a contract will depend on:

Answer 4

The design of the contract

The frequency of payment of premium

The relationship between the pricing and supervisory reserving bases

The additional solvency capital requirements

The level of initial expenses

Question 5

Define a whole life assurance.

Answer 5

A whole life assurance is a contract to pay a benefit on the death of the life insured whenever that might occur. A surrender value could also be available.

Question 6

Define a term assurance.

Answer 6

A term assurance is a contract
- To pay a benefit on the death of the life insured within the term of the contract chosen at the outset
- Typically, no benefit is available at surrender
- Premiums could be paid regularly over the term (or some shorter period) or as a single premium at the outset

Question 7

Define and immediate annuity.

Answer 7

An immediate annuity is a contract to payout regular amounts of benefit provided the life insured is alive at the time of payment. Immediate indicates that the contract starts payments immediately. The contract is usually purchased by a single premium, this premium may be the proceeds of another contract.

Question 8

Define a deferred annuity.

Answer 8

A deferred annuity is a contract to pay out regular amounts of benefit provided the life insured is alive at the end of the deferred period when payments commence, and subsequently alive at the future times of payment.

As there is a deferred period, regular or single premiums may be payable up to the vesting date.

Question 9

Define conventional without-profits.

Answer 9

Conventional without profits are characterised by fully guaranteed benefits and, usually, level regular premiums (depending on the product).

Question 10

Define with-profits contract.

Answer 10

A with-profits policy is one where:
- The policyholder has a share in the surplus arising within the with-profits fund
- The policyholder is entitled to receive part of the surplus of the company. The extent of the entitlement is usually at the discretion of the company

Question 11

Define unit-linked.

Answer 11

Unit-linked is a policy where the benefits are linked directly to the investment performance of a specified fund, and characterised by a lower level of guarantees on benefits and premiums.

Question 12

Define index-linked.

Answer 12

Index-linked is a policy where the benefits are linked directly to a specified investment index or economic index, and are guaranteed to move in line with the performance of that index.

Question 13

Define a unit fund.

Answer 13

A unit fund defines the policyholders basic benefit, and a company has a liability to pay this amount at the time of claim.

Question 14

Define a non-unit fund.

Answer 14

The non-unit fund can be thought of as being the accumulated value of all charges the company has taken out of its unit-linked policies, less all actual costs it has incurred on behalf of those contracts, less any distributions of profit it has made to its providers of capital, plus any capital injections paid in (for example, in order to pay for setting up reserves). The actual costs will include actual expenses, plus any additional claim costs over and above the amounts of unit fund paid out ( e.g. the extra amounts required to make up any total guaranteed sum assured for those policyholders who die).

Question 15

What is, and what is the aim of, actuarial funding?

Answer 15

Actuarial funding is a technique whereby life insurance companies can hold lower reserves for unit-linked contracts to which it can be applied, and thus can reduce new business strain.

Is a method which a life insurance company can use to reduce the size of the “unit reserves” it needs to hold in respect of its unit-linked business. The company effectively capitalises some or all of the unit-related charges it expects to receive from the units it has nominally allocated, with the funding being repaid from these future charges as they are received. When associated with appropriate surrender penalties it enables the company to reduce its financing requirement.

Question 16

What are the purpose of reserves?

Answer 16

The purpose of reserves are to:
- Demonstrate solvency to the supervisory authorities
- To investigate the realistic/true position of the life insurance company
- To help determine the long-term sustainability of profit distribution rates as well as current bonus declarations
- To help determine the realistic profitability of the company for the information of shareholders and management
- To assist in the general financial management of the life company

Question 17

With regards to negative non-unit reserves, what may regulation specify in a prudential valuation. (PANS)

Answer 17

The sum of the unit reserve and non-unit reserve for a policy should not be less than any guaranteed surrender value.

The future profits arising on the policy with the negative non-unit reserve need to emerge in time to repay the loan.

After taking account of the future non-unit reserves, there are no future negative cashflows for the policy (there is no future valuation strain).

In aggregate, the sum of all non-unit reserves should not be negative (from a select group of policies in the company’s business - regulation dependent).

Question 18

The supervisory authority’s primary concern is to ensure that insurance companies have sufficient assets to cover their liabilities with a high degree of certainty. This could be achieved by:

Answer 18

Requiring insurance companies to hold reserves calculated on a prudent basis

Requiring a minimum level of solvency capital to be held

Requiring a combination of prudent reserves and solvency capital to be held

Question 19

Define a market consistent valuation of a liability

Answer 19

A market consistent value of a liability should be determined as the price that someone would charge for taking responsibility for the liability, in a market in which such liabilities are freely traded. Where this information is not available approximate measures are used.

Question 20

The purpose of solvency capital requirements is to provide an additional level of protection for policyholders. It will protect policyholder against:

Answer 20

• the reserves being underestimated (adverse future experience relative to the reserving basis assumptions)
• a drop in asset values (including individual asset defaults)

Question 21

What is the aim of a risk-based capital approach.

Answer 21

The aim of a risk-based capital approach is to set aside an extra amount of capital, where the amount of capital is appropriate to the extent of the risks involved.

Question 22

Define the Value at Risk approach, and how is it used.

Answer 22

The VaR approach is a risk-based solvency capital required approach, it calculates the amount of capital an insurance company need to hold for a minimum required confidence over a defined period.

So the insurer calculates the amount of capital it needs so that its assets will exceed its liabilities in one year’s time with probability of 0.995 say.

For example, a VaR of 10 million over the next year with a 99.5% confidence interval means that there is only a 0.5% expected probability of losses being greater than 10 million over the next year.

VaR estimates the maximum potential loss a portfolio can experience over a given time frame, based on a specified degree of confidence.

Question 23

Define a passive valuation approach.

Answer 23

A passive valuation approach is one which uses a valuation methodology:
- Which is relatively insensitive to changes in market conditions.
- Where the valuation basis is updated relatively infrequently

Question 24

What are the advantages and disadvantages of a passive valuation approach. (SSS BOF)

Answer 24

Advantage
- more straightforward to implement
- less subjectivity involved
- (to the extent that they are used for accounting purposes) result in relatively stable profit emergence

Disadvantage
- becoming out of date as it is relatively insensitive to changes in market conditions
- valuation basis which is updated relatively infrequently may not take into account important trends (rising expense inflation or deteriorating claims experience)
- danger that it provides a false sense of security and management fails to take appropriate actions

Question 25

Define an active valuation approach.

Answer 25

An active valuation approach is one which uses a valuation methodology: - Which is based closely on market conditions - Where the valuation basis is updated frequently

Question 26

What are the advantages and disadvantages of using an active valuation approach. (IG CCV)

Answer 26

Advantages of an active valuation approach: - More informative in understanding the impact of market conditions in the ability of the company meeting its obligations - Particularly in relation to financial guarantees and options Disadvantages of an active valuation approach: - More complex - More costly - Results more volatile

Question 27

Define an income protection (IP) product.

Answer 27

An IP product is used to replace part of the income that the insured life would have earned if they become unable to work (referred to as incapacity) due to accident or illness. IP therefore pays a benefit in the form of a regular income (short- or long-term payments during periods of incapacity). IP benefits are in the form of a temporary annuity that continues until the insured recovers, dies or the annuity term ends, whichever occurs first. The regular income may be commutable to provide a lump sum, but this is not generally the case.

Question 28

Policy conditions should aim to: (ICU)

Answer 28

Reflect the true intentions of the office Give some cushion against adverse events over which the office has no control, for example if the office feels unable to assess the extra cost of claims that would result if war was declared, it should use policy conditions to exclude these claims Be as far as possible, simple and unambiguous, so as to assist the sales, underwriting and claims processes.

Question 29

Define a critical illness policy.

Answer 29

The benefit under a critical illness policy is typically a lump sum that is payable if the policyholder suffers one of the defined conditions. The product may also offer the lump sum to be paid in instalments, with any outstanding amount payable on death (if applicable). The lump sum is usually used to purchase an impaired life annuity that provides a regular income from date of a valid claim until death. The critical illness benefit is generally payable upon: the happening of a critical illness event; on reaching a defined degree of impairment; on undergoing a surgical procedure.

Question 30

What are the major advantages of the revalorisation method?

Answer 30

Advantages of the revalorisation method: - It is simple to apply - Relatively cheap to administer - This method codifies exactly how the company should declare part of its profits as a bonus to with-profit policyholders, very little judgement is required, the only exception is if the policyholder participates in the insurance profit - Protects policyholder from ungenerous life companies - By taking assets at book value a smooth emergence of profit is usually achieved

Question 31

What are the major disadvantages of the revalorisation method

Answer 31

The company has no discretion in its profit distribution Equity investment is discouraged, because of the fact that there is no deferral of profit distribution, this means all investment losses are borne by the company which would constitute insolvency risk Versions that do not share insurance profit with policyholders goes against the principle of mutuality Not very easy to explain to policyholders with “constant premium” policies, who see very small additions to their guaranteed benefits early in the policy term

Question 32

Define anti-selection.

Answer 32

Anti-selection occurs when people will be more likely to take out contracts when they believe that the risk which they pose is greater that the risk the insurance company has allowed for in its premiums. Anti-selection also arises where existing policyholder have the opportunity to exercise a guarantee or an option. Those who have the most to gain from the guarantee or option will be most likely to exercise it.

Question 33

What is the appraisal value of a life insurance company?

Answer 33

It is the sum of the embedded value of the company and the value to its shareholders of the future profits they expect to receive from future new business. The latter part of the appraisal value is often referred to as the "goodwill" value of the company.

Question 34

Define embedded value.

Answer 34

This is part of the appraisal value of the life insurance company. It represents the present value of shareholder profits in respect of the existing business of a company, including the release of shareholder-owned net assets.

Question 35

What is the purpose of the "management box" of an internal unit-linked fund, and what are the risks associated with the "management box"

Answer 35

Some companies create more units in their internal unit-linked fund than is strictly necessary to cover the corresponding unit liabilities. The "management box" are these additional funds. The purpose of the "management box" is to reduce the need to cancel or create units for a given day. Risks: - The most significant risk here is that the value of the underlying assets, so the value of the units that the company is holding for its own account decreases. For this reason, companies that use a box will normally keep it as small as practical given the degree of unit flows that arise from their policyholders. - There is also a risk that the expenses of managing a box are higher than expected. - There are operational risks, for example in keeping track of which units belong to policyholders and which to the company.

Question 36

What is the basic equity principle of unit pricing for an internal fund?

Answer 36

The interests of unit-holders not involved in a unit transaction should be unaffected by that transaction. Unit-holders should not be affected by the creation or cancellation of other units, otherwise cross-subsidies between unit-holders will arise. The creation and cancellation of units should not give rise to a change in the net asset value per unit.

Question 37

Define the appropriation price

Answer 37

The appropriation price is the price at which the company will create a unit. This can only be achieved if the amount of money put into the fund for each new unit appropriated is such that the net asset value per unit is the same after, as before, the appropriation.

Question 38

Define expropriation price

Answer 38

The expropriation price is the price at which the company will cancel units. This can only be achieved if if the amount of money the company takes out of the fund for each unit expropriated is such that the net asset value per unit is the same after, as before, the expropriation.

Question 39

What is the "broad equity" approach?

Answer 39

The "broad equity" approach specifies that the pricing basis is only changed if there is significant cashflow movement against the existing basis (if there is a significant net cash inflow for a fund being priced on a bid basis). This approach provides broad equity between different unit-holders and reduces price volatility. Sometimes companies use a management box to minimise changes to the basis.

Question 40

State key features of the bonuses relating to the conventional with-profits policies.

Answer 40

- surplus arises on the policyholders fund from interest, mortality, expenses and possibly lapses, the surplus is distributed by means of regular reversionary bonuses, special reversionary bonuses and terminal bonuses. - surplus distribution is normally determined for fairly homogeneous groups of policies by product and by duration. - comparison is made with the smoothed asset shares at maturity to determine appropriate payouts for each group - the method allows for smoothing of bonuses over time - this method allows a higher proportion of equity and property investment (more for conventional than AWP) - this method allows the actuary to apply judgmental considerations - any perceived inequity between policyholders may be difficult to explain or justify, this method is less transparent than AWP

Question 41

State key features of the bonuses relating to accumulating with-profit (AWP) policies.

Answer 41

- the benefit takes the form of an accumulating fund of premiums where profits are distributed by means of regular bonuses (applied as a proportion of the fund, and often on a daily basis) and terminal bonuses (added to the fund at the time of claim) - under this method it is more common for investment surplus only to be distributed (although other sources of surplus can also be distributed). - the accumulating benefit fund could have a unitised structure - surplus distribution is normally determined for fairly homogeneous groups of policies by product and by duration. - comparison is made with the smoothed asset shares at maturity to determine appropriate payouts for each group - the method allows for smoothing of bonuses over time - this method allows a lower proportion of equity and property investment (more for conventional than AWP) - this method allows the actuary to apply judgmental considerations - any perceived inequity between policyholders is easier to explain or justify, this is because the AWP is more transparent than conventional

Question 42

State key features of bonuses applied on the contribution method for with-profit policies.

Answer 42

This method identifies the investment, mortality and expense surplus arising on individual policies. The actual experience rates used to calculate these individual surplus contributions would be based on the experience of broadly homogeneous groups of policyholders. The surplus could be distributed by means of: - An addition to the guaranteed benefit - Reduction in premium - Cashback to policyholders - Retention of surplus for eventual “terminal dividend” distribution on claim/maturity The total distributable surplus each year is determined by the company, so there is some discretion for smoothing of the profit distribution over time. The subdivision of the surplus between homogeneous groups is mostly driven by a pre-set formula, which results in profits being distributed in proportion to the groups’ contributions to that profit. Some judgement will be necessary in allocating any unusual sources of surplus to policies (from large capital gain from property). The ability to invest in volatile assets such as equities and property would normally depend on the relative amount of terminal dividend being used.

Question 43

State key features of bonuses applied on revalorisation method for with-profit policies.

Answer 43

Under this method, the investment surplus on the policyholders’ fund is distributed to all with-profits policies by means of an increase in reserves. This increase in reserves is effected by means of an increase in benefit, and there may also be an increase in premiums. The surplus may also be calculated to include a mortality and expense contribution…although such items may be considered as a reward for the insurance risks undertaken and hence reasonably distributed entirely to the shareholders. The method treats all policies in the same way, and is formula driven (objective). No profit deferral occurs, hence discouraging investment in more volatile assets.

Question 44

What are the reasons for using reinsurance.

Answer 44

Limit the total amount paid on any particular claim Limit the total claims payout Reduce insurance parameter risk Reduce claims payout fluctuations Receive technical assistance Reduce new business strain Increase profits, return or risk adjusted return on capital (by reducing risk cost or increasing volumes) Reduce capital requirements of the insurance company Reduce capital requirements by using a reinsurer's capital (reinsurers may have lower capital requirements due to risk diversification) Separate out different risks from a product

Question 45

What are considerations a company may take before choosing reinsurance.

Answer 45

cost of reinsurance retention limits counterparty risks - increase number of reinsurers and/or use deposit back legal risks type of reinsurance amount of reinsurance (choosing retention limits)

Question 46

Experience will be monitored as part the control cycle so as to: (UTIA)

Answer 46

update assumptions as to future experience, thereby feeding back into the control cycle to monitor any adverse trends in experience as as to take corrective actions provide management information develop earned asset shares

Question 47

What is an important requirement when monitoring experience.

Answer 47

The most important requirement when monitoring experience is a reasonable volume of stable, consistent data for the experience investigations. The data should be of sufficient size to allow credible analysis down to the level of broad product groups split by the relevant risk factors. Experience investigations will typically include mortality, persistency (withdrawals) and expenses.

Question 48

Why would a company want to analyse the surplus arising over a year.

Answer 48

to show the financial effect of divergences between the valuation assumptions and the actual experience, exposing which assumptions are the more financially significant show the financial effect of writing new business provide a check on the valuation data and processes, if carried out independently identify non-recurring components of surplus, thus enabling appropriate decisions to be made about the distribution of surplus to with-profit policyholders give management information on trends in the experience of the company comply with regulatory requirements an analysis of surplus is a breakdown of the surplus arising over a year into elements, surplus/loss due to differences between actual experience and valuation assumption could arise due to investment, mortality, expenses, withdrawals and new business.

Question 49

Define underwriting.

Answer 49

Underwriting is the process of consideration of an insurance risk. This includes assessing whether the risk is acceptable and, if so, setting the appropriate premium, together with the terms of cover. It may also include assessing the risk in the context of the other risks in the portfolio.

Question 50

Reasons for underwriting. (FASTER)

Answer 50

help ensure that all risks are rated fairly protect the insurer against anti-selection identify the lives with substandard health risk identify the special terms to offer the substandard risks help ensure that mortality experience is consistent with the pricing basis reduce the risk from over-insurance (through financial underwriting)

Question 51

 List the principles that should be considered in determining the methodology for policy alterations. (AA EE SARB FP)

Answer 51

Affordability Anti-selection risk managed Ease of explanation to policyholders Ease of calculation, administration and documentation Stability (over time and duration) Alteration terms used by competitors Method allowed by regulation and professional guidance Boundary conditions consistent Fairness between shareholder and policyholders and a reasonable amount of profit Policyholder reasonable expectations

Question 52

In determining how to calculate paid-up sums assured, what principles should be considered. (ALS)

Answer 52

Paid up sums assured should be supported by the earned asset share at the date of conversion on the basis of expected future experience. Paid up sums assured should at later durations, be consistent with projected maturity values, allowing for premiums not received. Paid up sums assured should be consistent with surrender values, so that the surrender values before and after the conversion are approximately equal.

Question 53

In determining how to calculate surrender values, what principles should be considered. (PELDAA CCC)

Answer 53

Surrender values should: - take into account policyholder's reasonable expectations - 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 the earned asset share, in aggregate, over a reasonable time period - avoid anti-selection against the insurer - be capable of being documented clearly - take account of surrender values offered by competitors - not be subject to frequent change, unless dictated by financial conditions - not be excessively complicated to calculate, taking into account the computing power available

Question 54

State the three principles of investment.

Answer 54

In order to minimise risk, a company should select investments that are appropriate to the nature, term and currency of the liabilities The investments should be selected so as to maximize the overall return on the assets , where overall return includes both investment income and capital gains The extent to which appropriate investments may be departed from, in order to maximize the overall return, will depend on the company's free assets Overall, the company should invest so as to maximize the overall return on the assets, subject to the risk being taken on being within the financial resources available to it

Question 55

What are some of the factors which should be considered in product design.

Answer 55

Profitability Marketability Competitiveness Financing requirement Risk characteristics Onerousness of any guarantees Sensitivity of profit Extent of cross subsidies Administration systems Consistency with other products Regulatory requirements Sustainable investment options Interaction between product design features

Question 56

What are the requirements of models (MP VVPFWCDR)

Answer 56

- Model points must represent the business accurately - Valid, rigorous and adequately documented - Different variables should behave realistically relative to each other - Parameter values must be set appropriately - The model should incorporate all material features of the business - Workings of the model must be easy to explain and understand - The model should not be overly complex - The model should be capable of subsequent development and refinement - The results of the model should be clearly displayed, verifiable and communicable to intended recipients

Question 57

The basis for a valuation should reflect: FML C

Answer 57

- Expected future experience - Margins to ensure adequacy of reserves - Legislation/regulation (for published reserves) - The need for consistency

Question 58

How could assumptions be set regarding mortality.

Answer 58

- assumptions will be required for the base mortality level and for the level of expected future mortality experience (improvements/worsening of mortality) - assumptions chosen should be based on the expected demographic profile of policyholders

Question 59

How could assumptions be set regarding expenses.

Answer 59

- an allowance for expenses should be included, which should reflect expenses expected to be incurred in administering the policy - allowance for a share of future expected overhead expenses

Question 60

How could assumptions be set regarding expense inflation.

Answer 60

- an explicit assumption will be required to allow for the future inflation of expenses - the inflation assumption could be based upon: -- current rates of inflation, for both prices and earnings, which can be based on recent actual experience of the life insurance company/industry -- expected future rates of prices and earnings inflation which can be based on the differential between the return on government fixed interest securities and on government index-linked securities

Question 61

How could assumptions be set regarding the valuation rate of interest.

Answer 61

- should have regard to the yield on government bonds or corporate bonds (taking default risk into account) - the level of reinvestment risk should be considered

Question 62

How could assumptions be set regarding taxation.

Answer 62

- an allowance for taxation will need to be included as an assumption either explicitly or implicitly within the assumptions

Question 63

Describe the inception / disabled life annuity approach to costing IP benefits.

Answer 63

The inception / disabled annuity approach makes use of two functions, the claim inception rate and the disabled life annuity to value the benefit. The claim inception rate is the probability that a claim will become payable to an individual in the year of age x to x+1, provided that the individual remains sick to the end of the deferred period. In order to derive the claims inception rate, one must multiply the sickness inception rate by the probability of remaining sick throughout the deferred period. The disabled life annuity is the present value at the date of claim inception of expected claim payments to individuals disabled after the deferred period until policy expiry. Allowance is made for any escalation of the benefit amount, interest and the probabilities of death and recovery between the end of the deferred period and the policy expiry date. The expected claims outgo is then calculated as the annual benefit amount multiplied by the disabled life annuity multiplied by the claims inception rate.

Question 64

Describe the multi-state modelling approach to costing IP benefits.

Answer 64

The multi-state modelling approach tracks policyholders through various stages of healthy and claiming as follows: - healthy premium payers - lives falling sick within the deferred period - lives becoming claimants following the deferred period - lives recovering, reverting to premium payers - lives dying Each subclass requires its own set of transition probabilities, these probabilities may vary according to the number of previous times that the cohort has been ill and all transition rates may be a function of the duration within that state. Assumptions regarding the proportion of lives in each state will be required. The value of the claims outgo will depend on the number of lives in the benefit-receiving states, in a given month. Premium income will depend on the number of lives in the premium-paying states, in a given month. Investment income and all expenses will also need to be allowed for. Transition intensities will be applied to each state to determine the numbers expected in the various states for the following month. The multi-state model can be very complex with hundred of sub-cohorts requiring assumptions. The multi-state model may be more technically accurate than the inception / disability annuity approach, though there is unlikely to be sufficient data available to follow this approach and in may lead to spurious accuracy. The increased granularity allows for sensitivity testing which is not easily achievable under the inception / disabled life annuity approach.