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					Faculty of Actuaries                        Institute of Actuaries


                           April 2005

              Subject SA3RSA — General Insurance
                      Specialist Applications

                       MARKING SCHEDULE

                                            Faculty of Actuaries
JB 17.1.05                                  Institute of Actuaries
    Subject SA3RSA (General Insurance Specialist Applications) — April 2005 — Marking Schedule

1        (i)    Options which could increase earned profit next year are:

                1.    Increasing written and therefore earned premium.
                2.    Reducing acquisition expenses.
                3.    Reducing internal expenses.
                4.    Reduce the cost of reinsurance.
                5.    Writing to a lower loss ratio (for new / renewing business).
                6.    Reduce the cost of claims for claims settling next year.
                7.    Speeding up the earnings pattern of the portfolio.
                8.    Getting a higher investment credit.
                9.    Change to reserve assumptions and methodology.

                For each option assume everything else unchanged:


                    For two year policies: earned in yr 1 = 50% * 1yr * 50% pol exposure =
                     25%. Therefore 75% earned in year 2. (At 18 mths = 50% * 1.5yr * 75%
                     pol exposure = 56% )

                    If all policies for 2 yrs then current profit of $20m will be split 25% from
                     yr 1 and 75% from yr 2 earnings. For $4m growth in next year’s earned
                     profits would require a $200m * 20% / 0.25 = $160m growth in
                     premiums, or 80%.

                    The portfolio premium would need to grow from $200m to $360m.

                    This is a very substantial increase which may be part of the plan for this

                    But may not be previously planned and could be a tough target.

                    Can the individual markets/offices deliver this?

                    Increase in premium likely to be restricted as niche market.

                    Over half is written in the London Market — subscription market —
                     therefore could increase its written lines on business.

                    But the company could be already writing large lines with cedants and
                     brokers unwilling to give Co A larger lines.

                    Would the loss ratio suffer by taking on larger volumes of business which
                     may not be as good quality as the existing business.

                    Would the acquisition costs suffer by accepting business from higher cost

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Subject SA3RSA (General Insurance Specialist Applications) — April 2005 — Marking Schedule

                Can the front office / back office cope? Would direct expenses increase to
                 cope with the new volume?

                Will the reinsurance programme be as efficient? How does the RI
                 premium adjust? Will RI aggregates be breached? How does the new
                 volume and business mix compare to the RI submission information?
                 Will the terms of the RI treaty have to be renegotiated?

                May breach statutory premium limits in some countries.

                Requiring the injection of capital into some countries.


                Acquisition expenses will be different from the different sources.

                Some sources will be higher than others. Some may be relatively very

                Could cut the amount of business from the highest cost sources.

                Could take a tough negotiating stand with all brokers to cut brokerage.

                Which may be possible if the company dominates this niche market.

                But may result in lower volumes if the brokers can place the business

                Could push for (more) direct business with very low acquisition costs.

                But again this may annoy brokers who may take business elsewhere.

                Could make commissions profit related so higher commissions only paid
                 on profitable business.

                But this will reduce the benefit of better business.


                Reduced over the last two years — have all efficiency savings already be

                It has taken 2 years to reduce expenses by 2%, there may be some savings
                 in the next year from previous/current actions.

                You are unlikely to achieve the full 20% improvement with expenses
                 alone, however a further 1% reduction in expense ratio would contribute
                 $2m to the required increase in profit.

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Subject SA3RSA (General Insurance Specialist Applications) — April 2005 — Marking Schedule

                Niche product, therefore specialists required in underwriting / claims,
                 massive savings probably not possible.

                Internal expenses consist of direct and indirect, much of the internal
                 expense will be out of the control of the portfolio manager.

                Closing an office or other drastic measure would probably not deliver the
                 earned profit in the required timescale — redundancy payments etc.

                Introduce new admin procedures to cut costs, but again this is unlikely to
                 be achievable in the required timescale.


                RI ―well used‖ and ―key to smoothing profits‖ so we expect a fairly high
                 recovery rate, assume 50%, but could be higher or lower.

                Must reduce the net cost of the reinsurance, so take into account
                 reinsurance recoveries as well as the outward premium. Not buying any
                 RI would not reduce the costs by 17%. If recoveries average 50% then
                 cutting all RI would be expected to increase profit by 8.5%.

                Reinsurance outward premium is $200m * 17% = 34m assuming 50%
                 recovery means that the cost will be $17m. Halving the reinsurance spend
                 will reduce the cost from 17m to 8.5m — increasing profits by 8.5m.

                RI looks to be the solution to the manager’s problem so we need to know
                 what the current arrangement is and what loss ratio it is running at.
                 Depending upon the insurance cycle may be able to cut reinsurance
                 premiums payable.

                It is possible, but unlikely, that reinsurance provides a net benefit to the

                Need to know when the RI incepts and any existing agreements — if
                 incepts mid year then will only be able to reduce the costs for a part year.

                Long term agreements may mean that no changes are possible.

                Reducing Xol reinsurance spend will increase the % volatility of the

                If Xol Reinsurance cover is reduced by:

                 –   cncreasing retention
                 –   reducing the limit
                 –   or retaining a self insured share across the programme

                Purchase reinsurance in-house and avoid paying brokerage.

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Subject SA3RSA (General Insurance Specialist Applications) — April 2005 — Marking Schedule

                Reducing QS reinsurance spend will not change the % volatility of the

                Ads / disads.

                This may not be what the manager is comfortable with. Manager may
                 prefer a less volatile / more certain result.

                Reducing the amount of reinsurance purchased may reduce the other
                 perceived benefits obtained from reinsurers e.g. market knowledge.

                Purchasing less reinsurance might also lead to higher capital requirements.


                Could write business to a lower Loss Ratio by tightening policy
                 conditions, increasing rates, and better risk selection.

                However, the team should already be writing the best business they can so
                 this could be a difficult task.

                Increasing premiums may lead to loss in business overall, depends upon
                 elasticity of demand.

                Alternatively the LOB may be writing to significant losses.

                So improvement should be much easier.

                The market cycle may be hardening making the task easier,
                or v.v.

                It may be possible to be more rigorous with renewals, exiting poor

                Statistical analysis of data may identify both good and bad business which
                 could be targeted for appropriate action.

                But writing higher business volumes works against writing to lower loss

                May identify one office with a higher loss ratio,
                leading to difficult decisions which the manager may not want to take.

                May mean axing some policies which have been written for many years,
                 and breaking longstanding relationships — difficult.

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Subject SA3RSA (General Insurance Specialist Applications) — April 2005 — Marking Schedule


                Profit is measured on an earned basis. So reducing incurred claims next
                 year would increase profits.

                Reduce margins in reserves would increase taxable profit in that year,
                 although this would increase the risk of reserve inadequacy.

                Could be more active in claims adjusting, settling outstanding claims for

                This may be possible in a specialist / niche LOB.

                But this should be being done already.

                This may increase loss adjustment expenses.

                But should be more than compensated by lower claims.

                But the strategy may not be successful.


                Accelerating the earnings pattern of new / renewing business will
                 accelerate earned premium next year.

                Thus accelerating earned profit.

                Assuming business written to a profit.

                But this can only be done once per policy.

                But may not be possible in this niche Lob.


                Not a lot can be achieved here. Investment return is credited according to
                 a company allocation.

                This may be achievable but is not an exercise which adds value to
                 company A. It benefits the manager at the expense of someone else.

                Increasing this portfolio’s credit would mean reducing the credit for
                 another portfolio.

                If the total investment return is to equal that earned.

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Subject SA3RSA (General Insurance Specialist Applications) — April 2005 — Marking Schedule

                Mean duration 4 years: Reserves then LR * 200m * 4 say 560m if writing
                 to 70% LR. (100 – 20% acq cost – 10% expenses) Interest say 4% p.a.
                 gives investment income of say 24m p.a. Varying by +25% increases
                 profit by $6m. This could deliver the required result , but this is not a
                 value added exercise


                Change Reserving Methodology to reduce claims incurred in the financial
                 year (or their present value). The extent to which this may be possible
                 depends on the manager’s sphere of responsibility or influence and the
                 legal constraints in the territories concerned.

                Discount reserves at a higher rate of interest if this is allowed.

                Extend mean duration of discounted business — discount according to a
                 slower payout pattern.

                Reduce case estimates.

                The above may be perfectly legal if a conservative approach is currently
                 taken, but care does need to be taken.

                These options do not add value to Company A, they impact the timing of
                 the emergence of profit.
                                                             1 mark each point (max 47)

     (ii)   Conflicts of interest / opposing views
            Reinsurance spend
            Investment return

            1. RI Spend

                Manager views RI as crucial to smoothing results. Elimination of large
                 losses is achieved by Xol not QS RI.

                17% of $200m is $34m which is a large cash spend.

                What the manager views as a large loss may be insignificant to the

                Manager may be buying down to very low retentions which Company A
                 would rather retain.

                Manager may be protecting extreme events which may be more efficiently
                 protected at group level.

                This may be even more acute for the smallest premium volume offices
                 where a moderate sized claim could lead to an underwriting loss.

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Subject SA3RSA (General Insurance Specialist Applications) — April 2005 — Marking Schedule

               Reinsurers aim to make a profit so the manager is ceding profit over the
                long term.

               RI arrangements could involve funded/finite deals which smooth profits
                but do not benefit Company A.

               Ceded RI may be with companies less financially secure than Company A.

               Some RI purchases may have more to do with relationships than any added

            2. Investment return

               Not a function of underwriting so can argue should not be part of the
                performance assessment.

               Manager may not be taking into account currency matching of reserves
               or matching by duration.

               Some currencies e.g. Japan, USA have much lower interest rates than the

               London Market business does not have to be £ denominated.

               Matching investments by duration, the manager’s view may be much
                shorter term.

               Investment managers should have their own targets, LOBs should not
                benefit / suffer from any deviation from target by the investment

               Managers view may not take into account the investment costs.

               Or the investible percentage of funds.

               The quality of investments may be different.

               The company is not necessarily invested in fixed interest investments and
                for the time being return on their investment return is set at a lower
                notional rate but in the long term will be higher.

               May be regulatory restriction for the company on what they can invest in
                and this affecting the notional return.

               Effect of tax on investment returns may be strict for the company than the
                individual thus affecting net of tax return.
                                                                1 mark each point (max 18)

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    Subject SA3RSA (General Insurance Specialist Applications) — April 2005 — Marking Schedule

2        (i)    The insurer has to submit a Financial Condition Report (FCR) to the FSB that
                includes a valuation of assets and liabilities.                          (½)

                This report should include an evaluation of all material risk factors affecting
                the solvency of the insurer.                                                  (½)

                Assets should be valued according to the prescribed method as set out in the
                Short Term Insurance Act 53 of 1998.                                       (½)

                Total Assets should exceed the Value of the Liabilities (VOL) plus a minimum
                capital requirement (MCR).                                                (½)

                Value of admissible assets – VOL = Excess assets                             (½)
                Excess assets – MCR = Free assets                                            (½)

                (Excess assets)/MCR should be greater than 1                                 (½)

                The VOL should be calculated by a Prescribed Method either with or without
                the services of an actuary.                                             (½)

                If an actuary is not used the liabilities should be valued as follows:

                Outstanding Claims Reserve : Case estimate + prescribed margin               (½)
                IBNR                       : Prescribed formula + prescribed margin          (½)
                UPP                        : 365th method + prescribed margin                (½)

                If an actuary calculates the reserves and margins he should be able to justify
                that the sum of the central estimate (50th percentile) and the margins are 75%
                sufficient (after allowing for discounting and reinsurance) over the whole
                portfolio.                                                                    (1)

                The MCR can be calculated using either a prescribed rules-based method or an
                Internal Model method (IMM)                                             (½)

                The MCR should be calculated at a 99,5% level of sufficiency.                (½)

                The MCR should be calculated on risk based approach and take into account:

                   Insurance risk
                   Investment risk
                   Concentration risk
                   Operational/System risk                                                   (1)

                Any IMM should be approved by the FSB and independently reviewed on a
                regular basis                                                       (½)

                The proposal also includes guidelines on risk management and disclosure. (½)
                                                                                    [Max 7]

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Subject SA3RSA (General Insurance Specialist Applications) — April 2005 — Marking Schedule

     (ii)   The prescribed formula to calculate MCR:

            Minimum (R10m, A + B + C + D),


            A = Insurance risk capital charge
              = a1 + a2
              = outstanding claims risk capital charge + premium liability risk capital
            B = Investment risk capital charge
            C = Concentration risk capital charge
            D = Allowance for any other material risk factor that is not covered
                elsewhere (e.g. currency risk)                                          (1)

            A       Insurance risk capital charge

                    Due to the risk that the true value of the net insurance liabilities is
                    greater than calculated by the prescribed VOL method.

            A1.     Outstanding claims risk capital charge (OCRC)

                    Claims reserves are net of anticipated reinsurance recoveries.            (½)
                    Must be calculated for each class of business                             (½)
                    OCRC =  Net O/S claims liability  O/S claims risk factor                (½)
                              All classes

            A2.     Premiums liability risk (PLR)

                    Due to risk that premiums for future exposures will be insufficient
                    Premium reserves are net of deferred acquisition cost.              (½)
                    Must be calculated for each class of business                       (½)

                    PLR =  Net premiums liability  Premium Liability Risk Factor
                             All classes                                                      (½)

     B      Investment Risk Capital Charge (INCC)

            Due to risk from excessive exposure to a particular asset ( including
            reinsurance recoveries)

            The Capital charge requires insurers to hold an amount of capital against each
            asset class that is proportional to the value of the asset.

            Asset related values are calculated after the application of valuation and
            admissibility rules.                                                              (½)

            INCC =  Value of admissible assets  Investment Capital Factor
                       All assets                                                             (½)

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Subject SA3RSA (General Insurance Specialist Applications) — April 2005 — Marking Schedule

             C        Concentration Risk Capital Charge

                      10% of last year’s net written premiums                           (½)
                      (Premium values are gross written premiums net of reinsurance but
                      before deduction of commission)                                   (½)
                                                                                   [Max 4]

     (iii)   Advantages

                  Risk based so assessment and framework needed so controls and systems
                  Use company specific data, therefore more accurate                      (½)
                  Company calculates — forced to assess and understand risks in more
                   detail — may lead to better management                                  (½)
                  Rigorous documentation                                                  (½)
                  Company can continuously monitor the amount they need and calculate
                   impact form changes in strategy, i.e. buying less reinsurance, changing
                   portfolio of business.                                                  (½)
                  Expected higher level of capital may reduce insolvencies                (½)


                  Complex, difficult to model and to validate model                        (½)
                  Higher costs                                                             (½)
                  May not be transparent                                                   (½)
                  Different companies may take different approach to modelling
                   assumptions (e.g. tails or correlations) which may lead to different levels
                   of capital being set.                                                    (½)
                  Need lots of data.                                                       (½)
                  Even with large database some risks are very subjective (e.g. cats and
                   operational risk)                                                        (½)
                  Expected higher capital may put SA companies at a disadvantage in
                   producing returns for shareholders.                                      (½)
                                                                                        [Max 6]

     (iv)    (a)      Sources of Insurance Risk

                         Variable exposures — need to project 3 years                     (½)
                         Outstanding claims risk                                          (½)
                         Premiums risk                                                    (½)
                         Loss projection risk                                             (½)
                         Concentration risk                                               (½)
                         Reinsurance risk                                                 (½)
                         Expense risk                                                     (½)

                      Insurance risk model

                         Projections period 3 years FSB requirement                       (½)
                         Per line of business                                             (½)

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Subject SA3RSA (General Insurance Specialist Applications) — April 2005 — Marking Schedule

                       Model attritional, large and cat losses separately                 (½)
                       Attritional — model loss cost as % of net earned premium. Use
                        normal/lognormal distribution                                      (½)
                       Large/Cat losses — need frequency and severity assumption
                        frequency — Poison
                       Severity — Lognormal or Pareto for Cat losses                      (½)
                       Use historic data converted to current times allowing for claims
                        inflation, line size change, profile of the account and rate changes
                        (to capture relative exposure) to parameterize distributions       (½)
                       RMS, Equecat, or other cat modelling software can be used for the
                        cat part                                                           (½)
                       Decide whether to model any clash losses impacting more than one
                        line of business or any correlations                               (½)
                       Discuss assumptions with management and the underwriters (½)
                       Check against business plan                                        (½)
                       Construct a stochastic model of the gross losses                   (½)
                       Include the terms of reinsurance treaties in the model and model
                        explicitly any recoveries and reinstatement premiums               (½)
                        (Ensure treaties operates in the desired fashion, e.g. cat treaty
                        recovers only cat losses, prop. treaty recovers all losses, XL treaty
                        either risk only or risk and event).
                       Back test the assumptions against prior years                      (½)
                                                                                       [Max 8]

            (b)     Correlations can be explicitly model by a normal correlation matrix or
                    by more extravagant copula’s, e.g. Clayton, Gumbal.                (½)

                    Example 1:    Correlation between loss types in one business line.
                                  Positive correlation between the Attritional loss
                                  distribution and the frequency distribution of large losses
                                  for the liability portfolio, i.e. higher attritional losses
                                  might be positively correlated with more large liability
                                  claims but no effect on the size of the large claims. (1)

                    Example 2:    Correlation between risk types
                                  Investment risk correlated with insurance risk — both
                                  dependent on inflation
                                  Investment risk correlated with liquidity risk —
                                  reinsurance failure
                                  Insurance risk correlated with credit risk — cat claim
                                  Insurance risk correlated with liquidity risk — large
                                  Operational risk correlated with insurance risk — bad
                                  management lead to high loss ratio’s        (any 2, ½ each)

                    Correlations can also be modelled as external clash events impacting
                    across many portfolio’s                                            (½)

                                                                                      Page 12
Subject SA3RSA (General Insurance Specialist Applications) — April 2005 — Marking Schedule

                    A storm or a flood affecting the property, crop and motor portfolio’s.
                    A mid air collision affecting the liability and aviation (Hull) portfolio’s
                    A utility failure affecting the property and engineering portfolio’s.
                    A general downturn in the economy affecting all portfolio’s.

                    Model the loss with appropriate frequency and severity distributions
                    and divide it between the different portfolio’s as deemed appropriate.
                                                                            (any 2, ½ each)

                        The risk appetite/willingness of the insurer to take on catastrophic
                         risk                                                              (½)
                        The insurer’s free capital                                        (½)
                        The regular process by which the insurer’s policies are reviewed by
                        management in the light of the result by class of business and
                         geographical region                                               (½)
                        Current market conditions, e.g. availability of adequate catastrophe
                         reinsurance cover and the terms of the cover                      (½)
                        The classes of business in which the insurer is engaged           (½)
                        The types of catastrophe risk which need to be addressed          (½)
                        Risk accumulation per geographical zone                           (½)
                        Grouping of zones for calculation purposes                        (½)
                        The perils that produce the greatest MER                          (½)
                        The return period of the relevant catastrophe and the sensitivity of
                         the MER to changes in the return period — serious of stress testing
                         scenario’s                                                        (½)
                         The insurer’s reinsurance strategy and changes to it and the effect
                         on the MER                                                        (½)
                         How regular will the calculation of MER be reviewed               (½)
                         Compare with FSB’s prescribed method for the concentration risk
                         capital charge                                                    (½)

                         The MER should however be based on the results produced by
                         modelling the insurer’s own experience                     (½)
                                                                                [Max 5]

            (d)     Anything sensible, e.g.
                    Net exposure of the company assuming a 250 year return period, i.e.
                    the 99,6th percentile of the aggregate net loss distribution. The MER
                    must include an allowance for the cost of one reinstatement premium
                    for the insurer’s catastrophe reinsurance.
                    The MER should be less than the company’s PML                         [1]
                                                                                   [Total 35]

                        END OF MARKING SCHEDULE

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