CA1-PU-17 (CMP Upgrade) FINAL (WITHOUT REPLACEMENT PGS) Upgrade/CA1-PU-17.pdf · 2016. 8. 31. · We offer the following tutorials in Subject CA1: • a set of Regular Tutorials (lasting

CA1: CMP Upgrade 2016/17 Page 1

The Actuarial Education Company © IFE: 2017 Examinations

Subject CA1

CMP Upgrade 2016/17

CMP Upgrade This CMP Upgrade lists the changes to the Syllabus objectives, Core Reading and the ActEd material since last year that might realistically affect your chance of success in the exam. It is produced so that you can manually amend your 2016 CMP to make it suitable for study for the 2017 exams. It includes replacement pages and additional pages where appropriate. Alternatively, you can buy a full set of up-to-date Course Notes / CMP at a significantly reduced price if you have previously bought the full-price Course Notes / CMP in this subject. Please see our 2017 Student Brochure for more details.

This CMP Upgrade contains:

• all significant changes to the Syllabus objectives and Core Reading. • additional changes to the ActEd Course Notes, Series X Assignments and

Question and Answer Bank that will make them suitable for study for the 2017 exams.

CA1: CMP Upgrade 2016/17

© IFE: 2017 Examinations The Actuarial Education Company

1 Changes to the Syllabus objectives

This section contains all the non-trivial changes to the Syllabus objectives. There are no changes to the Syllabus objectives.



2 Changes to the Core Reading

This section contains all the non-trivial changes to the Core Reading. Chapter 1 Pages 7 & 8 There is additional Core Reading to be added to the penultimate paragraph of Section 3.1 on page 7 on the mandatory professional skills course. The Core Reading on page 8 has been rewritten. Replacement pages 7 to 12 are included at the end of this document. Page 14 There is additional Core Reading to be added after the first paragraph, replacement pages 13 and 14 are included at the end of this document. Page 16 There is additional Core Reading to be added to the end of the first paragraph of Section 5.3, replacement pages 15 and 16 are included at the end of this document. Chapter 4 Page 22 In the third paragraph of Core Reading on the page, change “Faculty & Institute” to “Institute and Faculty”. Chapter 32 Page 11

Remove the penultimate bullet point referring to expenses as a percentage of the sum insured / assured.



Chapter 36

Page 21

The seventh and eighth paragraphs of Core Reading have been replaced, replacement pages 21 and 22 are included at the end of this document. Chapter 43 Page 4

Section 2.3 on Value at Risk has been re-written, replacement pages 3 and 4 are included at the end of this document. Chapter 46 Page 10

The beginning of Section 3 has been extended by an additional paragraph of Core Reading and a Core Reading example. An additional ActEd paragraph of explanation has been added at the end of Section 3.1 and Section 3.2. Replacement pages 9 to 16 are included at the end of this document. Chapter 47 Page 3

In the first sentence of Section 1.2, change “becomes” to “became”.

Page 5

Remove the second sentence of the second paragraph:

“Thus it is likely that most companies will use the standard model, although there is likely to be significant variation: in the UK the majority are expected to use an internal model.”



3 Changes to the ActEd Course Notes

This section contains additional significant changes to the ActEd Course Notes. However, if you wish to have all the changes to the ActEd Course Notes, you will need to buy a full set of the up-to-date version (which you can do at a significantly reduced price if you have previously bought the full-price Course Notes / CMP in this subject). Chapter 0 Page 1

In the fifth bullet point, replace the word “advise” with “advice”.

Chapter 7 Page 14

In the first paragraph of Section 6.1, replace “an AIDS test” with “a test to detect for HIV”.

Chapter 12

Page 9

In the example at the bottom of page 9, add “= 0” at the end of the equation.

Chapter 29 Page 31

In the second part of Self-Assessment Question 29.18, change “allowed for in the use of the model” to “minimised”.

Page 44

The solution to Self-Assessment Question 29.18 (ii) has been amended. Replacement pages 43 to 45 are included at the end of this document.

Chapter 32

Page 16

Remove the second bullet point in the last list, referring to percentage of the sum assured or benefit.



Chapter 34 Page 28

In the solution to Self-Assessment Question 34.11, remove the phrase:

“does not want to sponsor future benefit accrual and”.

Chapter 35

Page 29

The hints in part (i) have been amended. Replacement pages 29 & 30 are included at the end of this document.

Pages 31 & 32

Self-Assessment Question 35.21 and the hints accompanying it have been amended. Replacement pages 31 & 32 are included at the end of this document.

Pages 46 to 47

The solution to Self-Assessment Question 35.21 has been amended, replacement pages 45 to 47 are included at the end of this document. Page 48 is no longer required.

Chapter 36 Pages 14 and 27

On page 14, an additional paragraph has been added before Self-Assessment Question 36.7. Replacement pages 13 and 14 are included at the end of this document.

On page 27, the solution to Self-Assessment Question 36.7 has been updated. Replacement pages 27 and 28 are included at the end of this document.

Chapter 38

Page 3

In Section 1.1, replace the paragraph below the “Key information” box with:

“If actual experience turns out to be different to what was anticipated then unexpected profits (or losses) may arise.”



Chapter 43

Page 15

Replace the definition of Value at Risk on the first summary page with:

Value at Risk represents the maximum potential loss on a portfolio over a given future time period with a given degree of confidence. Chapter 46

Page 18

In the section headed “Capital management tools”, replace the first paragraph with:

There is a range of financial tools available to providers to help them with capital management. The effectiveness of any particular tool depends upon the regulatory and tax environment within which the insurer operates. These tools include:

Chapter 47

Page 9

In the first sentence of Section 3.1, replace “(ie Solvency I)” with “(ie Solvency II)”.



4 Changes to the Q&A Bank The most significant changes to the Q&A Bank are given below.

Part 1 Questions Page 4 Change the number of marks in Question 1.19 from [4] to [5]. Part 1 Solutions Page 14 The bullet point list in the solution to Question 1.19 has been re-written to reflect a change to the Core Reading. Replacement pages 13 and 14 are included at the end of this document. Part 9 Solutions Page 12 In Solution 9.10, in the section headed “Value at Risk”, the second sentence of the first paragraph has been re-written in the light of the Core Reading changing. Replacement pages 11 and 12 are included at the end of this document.



5 Changes to the X Assignments

This section outlines the changes that have been made to the X Assignments.

If you wish to have all the changes to the X Assignments, you will need to buy a replacement CMP (which you can do at a significantly reduced price if you have previously bought the full-price CMP in this subject).

However, if you wish to have your assignments marked by ActEd this session then you can order the current assignments free of charge if you have purchased them in the same subject the previous year (ie sessions leading to the 2016 exams), and have purchased marking for the 2017 session. Assignment X7 Solutions Page 13 In the solution to Question X7.5(iii) on page 13 in the fourth to last point from the bottom of the page, remove “, sum assured”. Page 17 The question and solution to Question X7.8 (i) and (ii) have been amalgamated and the point about expenses being loaded as a percentage of the sum insured/assured has been removed. Replacement pages 17 to 20 are included at the end of this document. Assignment X9 Solutions Page 8 In the solution to Question X9.5(i) the Core Reading definition of VaR has changed, amend the first point of the solution to: Value at Risk (VaR) represents the maximum potential loss on a portfolio over a given future time period with a given degree of confidence. [1]



6 Other tuition services In addition to the CMP you might find the following services helpful with your study.

6.1 Study material We offer the following study material in Subject CA1: • Online Classroom

• Flashcards

• Sound Revision

• MyTest

• Revision Notes

• ASET (ActEd Solutions with Exam Technique) and Mini-ASET

• Mock Exam A

• Additional Mock Pack. For further details on ActEd’s study materials, please refer to the 2017 Student Brochure, which is available from the ActEd website at www.ActEd.co.uk.

6.2 Tutorials We offer the following tutorials in Subject CA1:

• a set of Regular Tutorials (lasting five full days)

• a Block Tutorial (lasting five full days)

• a Revision Day (lasting one day) For further details on ActEd’s tutorials, please refer to our latest Tuition Bulletin, which is available from the ActEd website at www.ActEd.co.uk.



6.3 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 ActEd’s marking services, please refer to the 2017 Student Brochure, which is available from the ActEd website at www.ActEd.co.uk.

6.4 Feedback on the study material ActEd is always pleased to get feedback from students about any aspect of our study programmes. Please let us know if you have any specific comments (eg about certain sections of the notes or particular questions) or general suggestions about how we can improve the study material. We will incorporate as many of your suggestions as we can when we update the course material each year. If you have any comments on this course please send them by email to [email protected].


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.

CA1-01: How to do a professional job Page 7


3 The professional framework of the Institute and Faculty of Actuaries

The professional framework of the Institute and Faculty of Actuaries comprises both ethical or conduct standards and technical or practice standards.

3.1 Professional conduct standards

The Institute and Faculty of Actuaries’ requirements are set out in the Actuaries’ Code. Detailed knowledge of the Actuaries’ Code is not required for examination purposes, but all actuaries should be aware of the issues that are addressed in the Actuaries’ Code. The Actuaries’ Code came into force on 1 October 2009 and forms part the Institute and Faculty of Actuaries Standards framework. The code is structured around the following five principles:

● integrity

● competence and care

● impartiality

● compliance

● communication. Further details on the framework can be found on the Institute and Faculty of Actuaries website: www.actuaries.org.uk. Professional skills and detailed consideration of the Actuaries’ Code are covered in the Institute and Faculty of Actuaries’ mandatory professional skills course, and actuaries subject to the Continuing Professional Development scheme are required to keep their professional as well as their technical skills up to date. Professionalism is essential in setting the scene for the context in which the actuary will operate. The basic principles of professionalism will determine the suitability of solutions to the problems raised. The Actuaries’ Code is therefore essential background to the consideration of the solution to any actuarial problem.

CA1-01: How to do a professional job


3.2 Technical and ethical standards

Members of the Institute and Faculty of Actuaries must comply with ethical standards issued by the Institute and Faculty of Actuaries as part of the regulatory framework and, where applicable, technical standards issued by the Financial Reporting Council (FRC). The FRC is a body that is independent from the Institute and Faculty of Actuaries Standards issued by the Institute and Faculty of Actuaries, called “Actuarial Profession Standards” (APSs) apply to all members of the profession, regardless of the territory or area of work in which they operate. These standards are principles-based. The Institute and Faculty of Actuaries’ regulatory framework ensures that our members meet appropriate professional standards by defining requirements for:

• ethical standards, including the Actuaries’ Code

• continuing professional development

• professional skills training

• Practising Certificates

• other non-mandatory resource material. The technical standards defined by the FRC are Technical Actuarial Standards (TASs) and Technical Memoranda (TMs). The aim of the TASs is to ensure that users of actuarial information can have confidence in “the information’s relevance, transparency of assumptions, completeness and comprehensibility”. TASs comprise:

• Generic TASs issued by the FRC. There are three of these: − TAS R (Reporting) − TAS D (Data) and − TAS M (Modelling).

• Specific TASs. These cover practice areas such as: − insurance (TAS I) − pensions (TAS P) − areas of activity such as business transformations (TAS T).

The TASs are developed in the context of UK legislation and regulations. They apply to work done in relation to the UK operations of entities and any non-UK operations which report in to the UK. However, for the Generic TASs wider adoption is encouraged by the FRC.



Work may depart from the requirements of a TAS if the departure is considered not to be material. In this context, something is material if, at the time the work is performed, the effect of the departure (or the combined effect if there is more than one departure) could influence the decisions to be taken by the users of the resulting actuarial information. Knowledge of the detailed technical content of actuarial standards is not required until the Specialist Application subjects. More information can be found on the FRC website, at www.frc.org.uk.

3.3 Exercising Judgement – Materiality and Proportionality

The TASs are principles based. This means that the TASs aim to move away from detailed, prescriptive rules and allow actuaries to focus instead on achieving desirable outcomes. These principles need to be considered when carrying out actuarial work that is within the scope of a particular TAS. We will first discuss the principles of materiality and proportionality, and then apply these to the TASs. Materiality The following definition of “material” is given in each TAS: “Matters are material if they could, individually or collectively, influence the decisions to be taken by users of the related actuarial information. Assessing materiality is a matter of reasonable judgement which requires consideration of the users and the context in which the work is performed and reported.” This means that a principle in a TAS can be ignored if it is felt that its inclusion would not have a material effect.

Example Principle C.5.3 of TAS D states that “The definitions of all items of data shall be documented.” Let’s say that you are carrying out a simple pricing exercise in which you find that only one factor has a significant impact on the risk and the other potential factors are found to be not useful in describing the risk.



So even though you may have looked at the other potential factors, you may not feel it necessary to document their definitions because they are not material to the pricing decision. You can therefore disregard principle C.5.3.

Proportionality Proportionality is not defined in the TASs. However proportionality is referred to in TAS R and TAS D as follows: “Nothing in this standard should be interpreted as requiring work to be performed that is not proportionate to the scope of the decision or assignment to which it relates and the benefit that users would be expected to obtain from the work.” This statement indicates that a principle which is material can be disregarded (without further consideration or comment) in some situations. For example, there may be a number of principles within TAS R that are material to a decision that the user needs to make but the making of that decision itself is immaterial to the user.

Question 1.4

Give a specific example of when a principle that is material may be disregarded.

In this situation the actuary could decide not to apply certain principles when carrying out or reporting the actuarial work. However, in such a situation there is still a professional requirement to ensure that anyone affected by the decision to be taken by the user is not adversely affected by this course of action. It is not possible to give any general advice on what is proportionate in any situation as the judgement will be driven by the individual circumstances applying to the specific user and the specific decision at the relevant time. Applying the principles of proportionality and materiality to actuarial work Where a principle is applicable and material in a specific context a judgement needs to be made as to how to apply the principle. If the judgement is that the principle should be applied, then the actual application of the principle should be carried out in a manner that is proportional. Judgements on the materiality and the proportionality of a principle in a specific context must be exercised in a manner that is both reasoned and justifiable.



When considering the application of a principle in a TAS, the principle can be put into one of the following three groups:

1. The principle is not applicable.

2. The principle is applicable but its inclusion is not material to the decision to be taken by the user.

3. The principle is applicable and its inclusion is material to the decision to be taken by the user.

Principles falling in group 1. are mainly matter of fact. Principles falling in group 2. and 3. require the exercise of judgement. In exercising this judgement the decisions for which the actuarial information is being supplied will need to be considered. This may involve discussions with the user. If a principle falls into category 3. then judgement will need to be exercised as to what is a proportionate application of that principle.



4 Doing a professional job

An important skill that you will develop in studying this subject is to think around issues and generate ideas about them, rather than pre-learning “appropriate responses” for every conceivable situation. As a forerunner to this, spend a few minutes considering the following question before going on to study the remainder of this section. As you then read on, consider where and why your answer differs from the Core Reading. As well as being good practice, this may make this unit more interesting to study(!).

Question 1.5

This section discusses actuaries doing a professional job. Without looking below, describe what you think “being a professional” means.

4.1 Being a professional

Professionalism is the way in which an actuary carries out the work and presents the advice resulting from the use of the skills acquired through this course and beyond. As a professional, an actuary will be required to make decisions and take personal responsibility for those decisions. An actuary must act with integrity and with detachment from his or her own personal circumstances. An actuary must also develop a direct, personal and trusting relationship with a client in order to advise on the most suitable solution for that particular client. An actuary must also recognise that the views of others (including other actuaries) may differ from his/her own and that the other views may be valid. A professional must achieve and demonstrate competence in his/her specialised skill, and its practical application, in order to build the trust of clients and the public in the advice that is presented. Additionally, an actuary should also maintain and improve competence in the skills that are necessary to provide actuarial advice. An actuary should also be reliable – in particular this means delivering a work product that meets the client’s requirements in terms of detail, quality and timeliness. Timeliness is often a major issue. An actuary should not promise to complete work in unrealistic timescales that might prejudice the detail or quality of the output. In the event that it becomes clear that the actuary cannot reconcile the detail, quality and timeliness of the work required, discussions with the client should be started at the earliest opportunity.



4.2 Know your client

When carrying out a professional task it is vital that the actuary knows who the client is. This involves:

● the need to have sufficient background about the client to put the task into context

● the need to know for whom in the client firm the work is being performed

● the need to know if there are any conflicts within the client firm – is the actuary advising for one side of an argument?

● what complaints procedures will be in place? For an employed actuary the client is obvious, but the other issues still need to be considered. Client agreements are becoming more common. These set out in writing the terms of reference for a particular task and outline the output to be delivered to the client. The terms of reference will then be agreed with the client to ensure that the actuary is carrying out the exact task that the client is looking to see completed, in the required timeframe.

4.3 Conflicts of interest

Advising different clients In many situations, different actuaries will be advising different parties in relation to the same transaction. For example, in a takeover or merger, actuaries may advise the vendor and a number of prospective purchasers. It is important that the different advisers are independent, particularly as they might all be analysing the same data. Ideally this should be achieved by advisors declining to take on work if they or their firm are already engaged in work for another party in the same transaction, or have other knowledge of the transaction, perhaps through an earlier assignment. To achieve this it is essential for consulting firms to keep detailed records of assignments so that actual and potential conflicts of interest can be declared to prospective clients. Occasions arise where conflicts of interest cannot be avoided.

Example A firm may be a specialist in a particular field, or there may be insufficient firms in a particular territory for each party to a transaction to use a different firm.



In this case the actuaries must disclose the conflict to their principals and establish measures to secure independence of teams working for different clients within the firm. These measures are commonly called “Chinese walls”. Originally physical separation of the different teams sufficed, but it is now just as important to ensure that electronic data is also tightly ring-fenced. The Institute and Faculty of Actuaries has produced substantial guidance on the issue of conflicts of interest which you should be aware of and apply in practice. This guidance can be found at: www.actuaries.org.uk/upholding-standards/conflicts-interest. You will not be tested on the detail of this guidance in the exam. The client and the client’s customers One of the more frequent conflicts of interest that an actuary may experience is between the interests of the client and the client’s customers. In an insurance scenario this would be between the insurer that the actuary is advising and the policyholders of the insurer; similar conflicts arise in other fields.

Example In the context of benefit schemes, the conflict might be between the sponsor and the members.

In some countries there is legislation or regulation to ensure that providers of financial products consider the interests of their customers. In the UK there is legislation that provides for unfair terms in contracts to be set aside, and a general regulatory requirement on regulated bodies to treat their customers fairly. This is covered in more detail later in the Course Notes.

Question 1.6

Outline some of the areas that might be regulated to help ensure consumers of financial products are treated fairly.

Where an actuary has statutory responsibilities, these frequently include the requirement to notify the regulatory authorities if the actuary believes that his client is acting in a way that would prejudice the interests of its customers. This requirement imposes a clear conflict of interest on the actuary. It is generally accepted that this type of requirement is necessary because of the complexity of financial products, their long duration, and the financial impact that unfair treatment could have on customers.



5 The task

Imagine you were asked to set out a procedure for completing a task at work. The procedure should be generalised so that it applies to any task rather than to a particular task and so should be free of detailed specifics. A plausible draft “procedure” would be:

● agree exactly what “the task” is and what problems will be addressed

● gather and assess the available information

● decide a method

● set assumptions

● arrive at “the solution(s)”

● check the solution(s) (and get somebody else to check)

● communicate the answer. This is broadly the procedure that the following Core Reading sets out. As you read it, it may strike you as “obvious”. We haven’t added many additional comments as there is little here that requires discussion or explanation.

5.1 General questions to ask before embarkation!

When carrying out a professional task an actuary needs to think through the project they are embarking upon. While proceeding through the task the end point needs to be considered:

● How will the results be reported in the business context and to whom?

● What will the implications of the results be and for whom? The task may end with the reporting of results or the making of proposals. However in many circumstances the actuary will be involved with the implementation and ongoing monitoring of proposals. In this case the following need to be considered:

● How will the implementation of the results or proposals be monitored?

● What can be learnt from the actual outcomes and how they compare with those expected?

● How will the actuary convey the additional insights he or she has gained during the task to the client?

● What resources are required?

● Is the timescale for completion of the task reasonable?



It will be vital to establish whether the outcome of the task taken on is purely advisory or will include any implicit or executive decisions. The next chapter on Stakeholders includes further consideration of different types of advice and where responsibility for decisions lies.

5.2 What is the problem?

Discussions will need to be held with the client to establish issues such as:

● Who owns the problem that needs to be addressed?

● A clear statement of the problem to be addressed

● Can the “big” problem be broken down into a series of smaller problems?

● What are the questions that need to be answered?

● Will the answers be relevant in finding an optimal solution to the problem?

The actuary then needs to consider the following:

● Does he or she understand the questions asked?

● Is he or she competent to answer the questions?

● Have the questions been agreed with the problem-owner?

● How does the problem-owner want the answers to be presented?

5.3 Answering the questions

In answering the questions, the actuary needs to have access to all the relevant facts. Where insufficient facts are available, is there other experience that could be used? If other experience is available what evidence is there to support the relevance of this experience to the current task? The actuary also needs to agree who will review his or her answers to the questions. If possible a peer review of the actuary’s work by another actuary or suitably qualified professional, before submission to the client, should be built into the process. The Institute and Faculty of Actuaries has issued an APS on peer review entitled APS X2 “Review of Actuarial Work” which you should be aware of. You will not be tested on the detail of this APS in the exam. Assumptions Any assumptions to be used will have to be determined. The effect of these assumptions on the answers must be considered. A means of recording the assumptions made will be needed. This will enable testing of them against future experience and may generate a feedback loop into the actuarial control cycle.

CA1-36: Valuing liabilities (2) Page 21


Solution (i) Suitability of the discount rate The nature of the discount rate (real or nominal) should be consistent with the nature of the cashflows being discounted. Therefore, using a real yield is appropriate only if the liability cashflows are based on real earnings growth (ie earnings growth in excess price inflation). One way of setting the discount rate is to use the return on assets that most closely replicate the nature, term, currency and certainty of the liabilities. Both the liabilities and assets are real. However, earnings growth (which affects the liability cashflows) may be greater than the price index on which the index-linked bond securities index is based. There may also be a duration mismatch, eg the duration of the long-dated bonds may be longer than the expected period of lost earnings, since the claimant is 50 and may have retired normally at age 60 or 65. It may be appropriate to consider using a lower discount rate than the real yield on the bond index. A lower discount rate would place a higher present value on the expected future cashflows, which could be used to reflect the uncertainties associated with the future liabilities, for example uncertainty over the duration of future employment. This approach is approximate, and consideration could be given to stochastically modelling the future cashflows to more accurately reflect the uncertainty in the future liabilities. Another way of setting the discount rate is to use the weighted average of the returns on the assets in which the claimant would be expected to invest. However, investing in index-linked bonds may not be what a financially aware person would do given the size of the award. It is also possible that the real yield on the bond index will be distorted by market sentiment – ie supply and demand for the bonds.

CA1-36: Valuing liabilities (2)


(ii) Mix of assets and factors to consider in setting the discount rate A typical individual investor would hold a mix of cash, bonds, property and equity in such a portfolio. Individual assets may be held but holdings in collectives are more likely. The factors that need to be considered in determining an appropriate discount rate are tax, dealing costs and charges, cashflow needs and security.

CA1-43: The risk management process (2) Page 3


The risk portfolio can then be extended to indicate how the risk has been dealt with:

● retained (and how much capital is needed to support it)

● transferred

● mitigated (and a revised assessment of the remaining risk)

● diversified (and a revised assessment of the remaining combination of risks).

The risk portfolio can also identify concentrations of risk and highlight the need for management action in these areas. The risk portfolio or risk register may be created at the “Risk identification” stage of the risk management process and then used throughout the process to manage and report on the risks.

CA1-43: The risk management process (2)


2 Risk measures

2.1 Asset risks

For investment portfolios, most attention has been devoted to measuring and managing the risks connected with an active investment approach. This was considered in Chapter 28 as part of investment management. As a reminder, the active risk measures introduced in Chapter 28 were historic tracking error and forward-looking tracking error.

2.2 Liability risks

The most common way of measuring liability risks is the analysis of experience – in other words the ratio of the actual occurrences of an event to the expected occurrences when the risk was accepted. Analysis of experience is dealt with in a later chapter as part of the control cycle. It is important to stress the need for consistent classification and measurement not only of the risk events, but also of the population exposed to risk. For example, a life insurer might analyse mortality, expense and withdrawal experience. It will be important when analysing decrements to ensure correspondence in the exposed to risk analysis.

2.3 Value at risk

Value at Risk (VaR) generalises the likelihood of underperforming by providing a statistical measure of downside risk. VaR represents the maximum potential loss on a portfolio over a given future time period with a given degree of confidence.

Examples A 99% one-day VaR is the maximum loss on a portfolio over a one-day period with 99% confidence, ie there is a 1% probability of a greater loss. A VaR of £10m over the next year with a 95% confidence interval means that there is only a 5% expected probability of the underperformance (relative to a benchmark) being greater than £10m over the next year. This example is shown in the diagram below.

CA1-46: Capital management (1) Page 9


Reinsurance companies can also contribute towards the initial capital strain of selling a block of life insurance business by contributing to the initial expenses by means of reinsurance commissions. This second use of reinsurance, as a source of capital, is known as financial reinsurance and we will cover it in more detail in Section 3.1.

2.4 Matching and managing capital needs

Matching and managing capital requirements is an area where actuaries are frequently called on to give advice. The primary tool needed to do this is a model of both the existing business and also the projected new business. The model can generate the amount of capital needed for the provider’s business plans to be achieved at a given ruin probability. A sophisticated model will also take into account any statutory or regulatory minimum capital requirements for the business throughout its lifetime.

CA1-46: Capital management (1)


3 Capital management tools

There is a range of financial tools available to providers to help providers meet their responsibilities and achieve their goals. Many are in common usage, whereas some are rare or relatively new. The effectiveness of a number of the tools outlined below will depend on the regulatory and tax environment that the insurer is operating in. It is also possible that the effectiveness of a given approach to managing an insurer’s capital may change over time if the regulatory / tax environment changes.

Example Within the European Union, financial reinsurance arrangements were historically used to improve the regulatory balance sheet of an insurer by crystallising the value of the insurer’s future expected profits. However the effectiveness of these types of arrangement has been reduced (or eliminated) under Solvency II. It is possible that alternative arrangements may be developed in future which will be more effective in allowing the insurer to manage its capital under Solvency II.

3.1 Financial reinsurance (FinRe)

FinRe typically consists of less transfer of risk than other forms of reinsurance and is, as its name suggests, more motivated by financial aims. Generally, the main aim of FinRe is to exploit some form of regulatory arbitrage in order to more efficiently manage the capital, solvency or tax position of a provider. It frequently relies on the regulatory, solvency or tax position of a reinsurer, which may be based in an overseas state, being different from that of the provider. By definition, this is done in the form of a reinsurance contract between the reinsured and the reinsurer. A typical example of exploiting a regulatory position is a contingent loan from the reinsurer to the insurance company. A normal loan would increase the insurance company’s assets, but there would be no strengthening of the statutory solvency position as the insurance company would also have to identify the amount owing as a liability. With a contingent loan, the repayments are contingent on, for example, the insurance company making profits in future on a block of business. Because the insurance company has no liability to repay the loan unless these profits emerge, it does not have to make any provision for these future payments on a statutory basis. Therefore the insurance company improves its statutory solvency position. Bear in mind that, as the company will repay the loan over time, the improvement is only short term.



Question 46.9

Why might this arrangement rely on the regulatory position of the reinsurer being different from that of the provider?

Question 46.10

Many reinsurance companies are based (or have subsidiaries) offshore, eg in Bermuda. Suggest possible reasons for basing a reinsurance company in an overseas state.

Whether FinRe improves the statutory solvency position depends upon the regulatory regime. For example, if the regulatory regime already allows future profits to be included as an admissible asset then the regulatory solvency position will not be improved by using FinRe. FinRe would though still have a role in changing an illiquid asset (future profit) into a liquid asset (the money received from the reinsurer) and so can help with cashflow management.

3.2 Securitisation

Securitisation involves converting an illiquid asset into tradable instruments. The primary motivations are often to achieve regulatory or accounting “off balance sheet” treatment. Typical transactions will be structured with an element of transfer of the risk associated with the value of the asset. This will result in any potential loss in value of the asset being capped. Almost any assets that generate a reasonably predictable income stream can in theory be used as the basis of a securitisation. Examples of illiquid assets that could be securitised are:

● future profits, eg on a block of in-force insurance policies

● mortgages (and other loans). Each of these could be securitised into tradeable instruments (eg bonds), in order to raise capital. The owner of the assets issues bonds to investors (eg pension funds, insurance companies and banks) and the future cashflow stream generated by the secured assets is then used to meet the interest and capital payments on the bonds. In practice, a separate legal vehicle is usually established to stand between the owner of the assets and the investors. The securitised assets are transferred into this vehicle.



Question 46.11

Why?

There is typically risk transfer as the repayments on the bonds are made only if, for example, the future profits emerge or mortgage repayments are made.

Example A portfolio of mortgage loans owned by a bank could be pooled together and the cashflows from these mortgages used to service the interest and capital payments on a bond. Securitisation of this type, that had been backed by sub-prime mortgages in the US, were the focus of much attention during the sub-prime crisis and credit crunch.

Similarly to the comments made in the previous section on FinRe, the benefits of securitisation in improving the statutory solvency position depend upon the regulatory regime. Also, as with FinRe, securitisation has a role in cashflow management, ie turning an illiquid asset into a liquid asset.

3.3 Subordinated debt

A provider can raise capital through issuing subordinated debt in the capital markets. The main aim of subordinated debt is to generate additional capital that improves the free capital position of the provider. The company issues debt, normally through a stand-alone subsidiary, which is guaranteed on a subordinated basis by the provider, ie the repayment of the debt is guaranteed only after the policyholders’ reasonable expectations have been met. As the debt repayment comes after all reasonable expectations of policyholders have been met, including non-guaranteed bonuses if any, the liability for repayment does not need to be included in the assessment of solvency. Again we have a method of raising capital that has increased the assets of the provider (by the amount of the debt issued) but, because the repayments rank behind the policyholder liabilities (ie are contingent on those liabilities being met), does not increase the liabilities. Therefore, once again the provider’s capital position may be improved. The debt can be dated or undated, though this will impact the amount available as an admissible asset and may impact the tax implications.



Question 46.12

What is an admissible asset?

3.4 Banking products

The banking sector provides some capital management solutions for the insurance industry directly (rather than as intermediaries as with securitisation). These include:

● liquidity facilities

● contingent capital

● senior unsecured financing

● derivatives. Liquidity facilities Liquidity facilities can be used to provide short-term financing for companies facing rapid business growth.

Question 46.13

Why would a period of rapid business growth be associated with an increased need for financing?

Contingent capital Contingent capital can be a cost-effective method of protecting the capital base of an insurance company. Under such an arrangement capital would be provided as it was required following a deterioration of experience (ie it is provided when it is needed).

Question 46.14

Contingent capital works on the same principle as one of the types of alternative risk transfer. Which one?

Although these arrangements clearly improve the financial strength of an insurer and can be given credit for by a rating agency, they lack visibility.



Question 46.15

Why is lacking visibility a disadvantage?

Senior unsecured financing Senior unsecured financing directly for an insurance company would not have capital benefits as the loan would be treated as a liability on the company’s balance sheet. Such a straightforward loan doesn’t help the company as it increases both the assets and the liabilities by the same amount. This contrasts with subordinated debt, which increases just the assets. However, financing at the group level can be used within a group structure to provide capital to insurance subsidiaries. It can be more cost effective than other forms of capital but clearly has financial strength implications at the group level. Capital can be moved around within a group of companies. Although this may improve the capital position of the insurer, the total amount of capital within the group as a whole is unchanged and so there must be a worsening of the capital position elsewhere.

3.5 Derivatives

Derivatives provided by banks, some of which may be highly structured, may be used for capital management. Since they are issued by banks they can be classed as a banking product in the section above. In general however, the market is sufficiently large for these products that they are usually considered as an asset class in their own right. Prudent management requires that any provider entering into derivative contracts must exercise caution. The provider needs to ensure that its derivative strategy assists in the efficient management of its business and serves to reduce risk. Derivatives contracts can be used either:

● to reduce risk (hedging), or

● to increase risk (speculation) in order to improve returns.



Prudent financial management of a financial services provider may involve hedging but should not involve speculation.

Example An example of when a derivative contract might be used is when a provider is concerned about the impact of a fall in its equity values. It could enter into a contract to protect its equity portfolio falling below a certain level. Potentially, the cost of this "downside protection" could be partially met by the sale of some "upside" potential via a second derivative contract.

Question 46.16

What types of derivative contract could be used to provide downside protection for a provider’s equity portfolio? How could the cost of this downside protection be met by selling the upside using a second derivative contract?

3.6 Equity capital

An obvious source of capital is simply to increase equity, which increases assets without increasing regulatory liabilities. The equity may come from:

● a parent company

● existing shareholders by a rights issue

● directly from the market by a new placement of shares.

3.7 Internal sources of capital

There may be ways to simply reorganise the existing financial structure of an organisation in a more efficient way:

● funds could be merged

● assets could be changed

● the valuation basis could be weakened

● the distribution of surplus could be deferred

● capital could be retained in the organisation possibly by not paying dividends to any shareholders.



Merging funds Merging funds would help if, for example, some of the regulatory liabilities or the solvency capital was calculated as a monetary / fixed amount per fund or had a fixed minimum. Changing assets

Question 46.17

Selling $100,000 of one asset in order to buy $100,000 of another asset leaves the total amount of assets unchanged. So, how can changing the assets improve the regulatory position?

Weakening the valuation basis Weakening the valuation basis would reduce the value of the liabilities relative to the assets, improving the reported solvency position. Note that this is only an acceptable course of action provided it could be justified! Deferring surplus distribution and retaining surplus Deferring the distribution of surplus to policyholders (eg by deferring bonus distributions) reduces the level of guaranteed policyholder benefits and hence the capital required.

CA1-29: Modelling Page 43


Solution 29.16

Liabilities are likely to be required to be valued individually since the regulators want assurance that the company has sufficient provisions to meet the claims of all of the actual policyholders and risks being covered – it is possible that an approximate approach using model points might lead to under-reserving. Solution 29.17

Redesign the product Where an assumption is very uncertain and would have a material financial impact the product may be redesigned to try to reduce the financial sensitivity to that assumption. Increase margins for prudence If that were to prove impossible, then it may be appropriate to include higher margins for that assumption than for other, less uncertain, assumptions. Solution 29.18

(i) Main requirements of actuarial models The main requirements of actuarial models used in the management of benefit schemes will be to model:

● the level and timing of benefit outgo

● the level and timing of contribution income

● investment returns (return on capital)

● investment strategy.

CA1-29: Modelling


The requirements for models are that they must:

● be valid, rigorous and well documented

● reflect the risk profile of the business being modelled

● allow for all the significant features of the business being modelled

● have appropriate input parameters and parameter values

● be communicable and the output verifiable

● not be overly complex or time consuming to run

● be capable of development and refinement

● be capable of being implemented in a range of ways. (ii) Limitations of models and dealing with them Limitation The results of a modelling exercise are only as good as the underlying model, ie prone to model error. Mitigation Consider lots of potential models, employ suitable expertise to identify the most appropriate model. Limitation The level and timing of cashflows is uncertain, eg dependent on longevity and so actual experience will differ from the model result. The sensitivity of the results and the likely extent of differences therefore need to be understood. Mitigation A stochastic model may be deemed appropriate as it can illustrate a wide range of potential outcomes, but consider whether the complexity of such a model is justified. It may be appropriate if options and guarantees arise in relation to the benefits. Limitation

The results of the exercise will depend upon the data used, ie there is a risk of data error if proper records of scheme members have not been maintained.

CA1-29: Modelling Page 45


Mitigation Ensure data is regularly updated, eg contact current pensioners and deferred members to check whether their details have changed. Limitation The results depend upon the suitability of the assumptions used, ie prone to parameter error. Mitigation Carry out lots of sensitivity testing to identify the key assumptions. Pay careful attention to the setting of those financial assumptions which are most important, eg investment return, mortality rate.



Hints (i) When faced with a situation in a question that doesn’t look familiar it’s

sometimes difficult to get a grasp of the issues or feel like you know where to start. You can start by addressing some of the key phrases in the question, for example:

● funding level, remember the funding level is assets over liabilities. What would cause the funding level to fall or rise?

● change in option pricing, what might happen to the take-up rate of the option? Remember this is a move to unisex terms.

(ii) In this part you need to consider why actual experience is different from what

was expected, so try thinking about the assumptions that make up the basis. (Don’t worry if you find this part tricky – sources of surplus is covered in more detail in a later chapter!)



Solution 2 (i) Possible effects on the schemes’ funding levels Following the change in option pricing to a unisex basis, it is possible that either a surplus or deficit will have arisen. The change will affect the cost every time a member reaches a position of deciding whether to exercise an option. The scheme will need to calculate the value of the benefit at the option date, which might depend on market conditions at that time. The values of the options on the revised factors and on the old factors will need to be compared. The change will also affect the take up rate of the option. A more generous basis for either males or females may make it more likely that the option will be exercised by individuals of that gender. For example, if there is a reduction in the female factor (which might be the case if the unisex factor is set in relation to the proportions of male / female members) then the take up rate for females may possibly reduce. (ii) Other possible sources of surplus or deficit The deficit will have emerged because the experience of the scheme in the inter-valuation period will have been different to the assumptions made at the last valuation and unfavourable overall. It is therefore necessary to identify each assumption and assess the experience relative to that assumption. The assumptions will include:

● financial factors

● demographic factors

● that the benefits payable won’t change

● the pricing of options

● that the valuation basis won’t change and

● that contributions at the balancing rate have been paid.



Examples of financial factors that will require investigation are:

● the rate of return on the scheme assets

● the rate at which salaries have increased (general salary inflation)

● the rate at which pensions have increased (if linked to price inflation). Examples of demographic factors that will require investigation are:

● the rate at which people have been promoted

● the corresponding salary increase awarded

● the withdrawal rate

● the rate at which early retirement options (if not cost neutral) have been exercised

● the mortality rate before retirement

● the mortality rate after retirement

● the morbidity rate.

Question 35.21 (Exam-style question)

A proprietary life insurance company (Company A) writes predominantly term assurance business. However, it also has a block of unit-linked regular premium endowment assurance policies that were written between four and ten years ago. It has no other unit-linked business, and is not minded to re-enter the unit-linked market. The computer systems on which the unit-linked business is administered are no longer supported and are approaching the end of their useful life. The company has been introduced to Company B which has expressed interest in acquiring the unit-linked business. Company B writes a wide range of unit-linked business. Outline the main items that would be considered by Company A and Company B in determining:

• an appropriate basis for assessing the transfer

• whether to proceed with the transfer of business.



Hints This question is about a transfer of liabilities. What strength of basis is likely to be viewed as fair by both parties? What financial and non-financial considerations are there in determining whether the transfer is a good idea? You can consider this separately from the viewpoint of Company A and Company B.



Solution 35.15

A best estimate basis can be thought of as fair to both the party transferred from and the party receiving the transfer, since if actual experience bears out the best estimate assumptions then the transfer will be cost neutral to both parties. Solution 35.16

Company X will prefer a prudent basis to be used. This will place a high value on the liabilities of Company Y’s scheme and hence result in a large amount of assets being transferred into Company X’s scheme. Furthermore, the transfer needs to be considered in the light of the overall deal. For example, allowances may be made in other areas of the deal. The agreement reached must also be acceptable to both sets of scheme trustees and be in line with the schemes’ rules. Solution 35.17

Options resulting in selection may include: (i) Term assurance – an option to renew a contract without further evidence of

continuing good health (ii) Household insurance – an option to have “new for old” cover rather than cover

on an indemnity basis may result in a higher proportion of fraudulent claims by policyholders looking to replace worn out goods.

Solution 35.18

Eligibility criteria might include:

● imposing a limit on the sum assured

● medical underwriting at outset to prove health

● restricting the age of the applicant.



Solution 35.19

“In the money” means that the guarantee is currently biting, eg where a unit-linked benefit has a guaranteed minimum value, this minimum benefit is greater than the current value of the units. Solution 35.20

We would need to use a stochastic approach or a variety of deterministic scenarios. Guarantees are best valued using a stochastic approach because multiple simulations can be run to estimate the likelihood of the guarantee biting. Solution 35.21

Appropriate basis for the transfer The basis used will be very important since a monetary transaction would take place, ie liabilities and assets have a real monetary worth. It is important to set a basis that both the transferring and receiving parties view as being fair. A best estimate basis might be viewed as fair to both parties … … but there are other factors to consider, for example the relative negotiating strength of the two parties … … and the desire by Company A to off-load the liabilities and by Company B to take the liabilities on. Whether to proceed with the transfer A company would wish for the transfer to proceed if it felt it offered good financial value, eg for Company B if the amount received to take on the liabilities at least compensates for the expected cost of those liabilities … … and there were no alternative better uses for funds. There will also be non-financial considerations to take into account.



Company A may be keen to proceed with the transfer since:

● if the transfer does not go ahead, a new administration system will need to be developed or purchased …

… and the costs of this will have to be spread over the existing (and diminishing) unit-linked policies

● it will receive a lump sum in cash. This will include an allowance for the value of future profits from the business. The statutory solvency position may improve (depending on the regulations in the territory concerned).

● if the business is retained then over time it will have fewer policies under administration, and therefore overhead expenses will have to spread over a smaller number of policies.

Company B may be keen to proceed with the transfer since:

● it offers synergies, eg Company B is likely to already have the necessary robust administration systems to administer the unit-linked business

● it is likely to benefit from economies of scale in the administration of additional business. Overheads can be spread more thinly.



2.3 Estimating fair values

As we saw under the mark to market approach in the previous section we can determine a risk-free discount rate. The risk-free market value is the present value based on discounting future liability cashflows at the pre-tax market yield on risk-free assets. In the UK, government securities are often referred to when considering risk-free assets. However, the range of government bonds has, until recently, not been of sufficiently long a term to match all insurance cashflows and some estimation of yields in respect of notional longer-term assets has been needed.

Question 36.6

Give an example of the type of liabilities that a general insurer may have for which available government bonds may not be available of a sufficiently long term to match.

2.4 Financial risk and fair value reporting

Financial risk associated with the liability cashflow is normally allowed for in a market consistent manner either by a replicating portfolio (ie a portfolio of assets which exactly matches the liabilities) or through stochastic modelling and the use of a suitably calibrated asset model. This means that, rather than discounting future liability cashflows at a risk-free rate, a higher rate is used. This is so as to reflect to some degree the higher returns expected on the (risky) assets actually held.

2.5 Mismatching risk and fair value reporting

The risks associated with the general mismatching of assets and liabilities are on the whole excluded from fair value calculations. This is because inclusion of this risk would be inconsistent with the general principle that the fair value of liabilities should be independent of the assets held to meet the liabilities.



2.6 Non-financial risks and fair value reporting

Operational risks (failures of people, processes and systems) and external risks are the key categories of non-financial risk. We will learn more about both financial and non-financial risks in a later chapter.

Question 36.7

Outline the non-financial risks to which a retirement benefit scheme is exposed.

The adjustment for non-financial risks can be achieved either by adjusting the expected future cashflows or by an adjustment to the rate used to discount cashflows. These adjustments will depend on:

● the amount of the risk

● the cost of the risk implied by market risk preferences.



Solution 36.6

Government bond typically have a maximum term of 25-30 years. A general insurer’s liability for claim payments may have a very long term for certain classes of business. For example, claims on employers’ liability policies due to asbestosis might take longer than 20-30 years to be noticed by an employee and another 5 years or more to be settled. Solution 36.7

A retirement benefit scheme will have the following non-financial risks: Operational risk: Inefficient administration systems, leading to higher than

expected expenses of paying benefits. Incorrect benefit calculations leading to over-payment of benefits

and therefore higher costs to the sponsor. Incorrect benefit calculations leading to under-payment of

benefits and therefore complaints and reputational risk to the scheme and sponsor.

External risk: The government introduces additional regulation that the scheme

must adhere to, eg minimum level of contributions or benefits. Tax breaks available to the pension scheme are removed,

increasing costs. Competitor companies offer a more attractive pension scheme. Solution 36.8

Best estimate assumptions and a single explicit contingency margin for caution:

+ The degree of caution introduced can clearly be identified.

+ Such a margin may be easier to explain to clients.

– It is difficult to assess the appropriate allowance to be made.



Prudent individual assumptions:

+ Margins can be targeted to the areas where they are required, for example if future mortality experience is particularly difficult to predict then the margin can be introduced in that assumption.

– Care needs to be taken in introducing margins within the basis, to ensure margins in different assumptions don’t cancel out or alternatively that many small margins lead to a basis which is too strong.

– Using lots of individual prudent assumptions lacks transparency and can be harder to explain to clients compared with a single explicit contingency margin.

Solution 36.9

The main disadvantages are:

● it is time-consuming and therefore expensive

● there is a risk that the case assessors may not have sufficient expertise leading to incorrect assessment

● the process is subjective and there is a risk of bias by the assessors

● this approach can only look at reported claims, a separate approach will be needed to evaluate incurred but not reported claims.

Solution 36.10

The provision for the unexpired duration is:

80% 0.75 200 120m¥ ¥ =

CA1: Q&A Bank Part 1 – Solutions Page 13


● setting the legislation to apply to private pension schemes, for example funding requirements, disclosure requirements and winding-up provisions [½]

● monitoring whether the legislation that has been set is being applied. [½] [Maximum 4] Solution 1.17

● It is compelled, or at least encouraged, to do so by regulation imposed by the State. [1]

● The employer wants to act in a paternalistic way towards its employees … [½]

… in particular it may want to reward loyal or key staff, and care for those in need. [½]

● It wants to attract and retain good employees … [½]

… and so offer benefits at least as good as key competitors. [½]

● In order to benefit from economies of scale, ie it may be cheaper to provide benefits to employees through a pooled arrangement than for employees to make their own individual arrangements. [1]

● The employer may be part of a multi-employer scheme that provides benefits. [½] [Maximum 4] Solution 1.18

An investment exchange ought to be required to demonstrate to the regulator that:

● it has adequate financial resources to provide the requisite exchange services [1]

● proper conduct of business rules exist, in particular … [½]

● … all parties (traders and issuers of securities) should be aware of the rules and understand them [½]

● these rules are monitored to ensure they are enforced … [½]

● … to prevent insider trading and fraud [½]

● it operates proper, transparent and sufficiently liquid markets in the securities traded [1]

● appropriate procedures for recording transactions exist, eg time, price and volume of each trade, and the parties involved [1]

● appropriate procedures exist for admitting new listings [½]

CA1: Q&A Bank Part 1 – Solutions


● proper arrangements exist for the clearing of transactions … [½]

● … to prevent fraud. [½] [Maximum 6] Solution 1.19

The professional framework of the UK actuarial profession comprises both ethical or conduct standards and technical or practice standards. [1] The Institute and Faculty of Actuaries’ requirements are set out in the Actuarial Profession Standards. [½] The Actuarial Profession Standards framework comprises:

● ethical standards, including the Actuaries’ Code [½]

● continuing professional development [½]

● professional skills training [½]

● Practising Certificates [½]

● other non-mandatory resource material. [½] Professional skills and consideration of the Actuarial Profession Standards are covered in detail in a two-day post-qualification course. [½] Actuaries subject to the continuing professional development scheme are required to keep their professional as well as their technical skills up to date. [½] The Financial Reporting Council sets and maintains Technical Actuarial Standards (TASs). These can be on either specific or generic topics. [½] The TASs apply to work done in relation to UK operations of entities and any non-UK operations which report in the UK. [½] The aim of the TASs is to ensure that users of actuarial information can have confidence in “the information’s relevance, transparency of assumptions, completeness and comprehensibility”. [1] Actuaries may only depart from these standards if the departure is not considered to be material. [½] [Maximum 5]

CA1: Q&A Bank Part 9 – Solutions Page 11


(ii) Two approaches to risk management If risk is managed at the business level then the parent company decides on its overall risk appetite and then divides this between the business units ... [½] ... the management of each business unit then manages the risks of the business within the allocated risk appetite. [½] If risk is managed at the enterprise level then a group risk management function is established. The risks of the various business units are identified and then the results combined into a risk assessment model at the entity level. [1] Advantages of managing risk at the business level Each business unit feels a sense of responsibility / direct involvement in risk management. [½] The management teams of the various business units are most closely involved in understanding the risks and how to deal with them. [½] Advantages of managing risk at the enterprise level This approach makes allowance for the benefits of diversification or pooling of risk. [1] It provides insight, at a group level, into the areas with undiversified risk exposures where the risks need to be transferred or sufficient capital set aside to cover. [½] Such an approach is important in ensuring efficient capital use across the group. [½] [Total 5] Solution 9.10

Five approaches to measuring investment risk Historic tracking error [½] This is the annualised standard deviation of the difference between portfolio return and benchmark return, based on observed relative performance. [½]

CA1: Q&A Bank Part 9 – Solutions


Forward-looking tracking error [½] An estimate of the standard deviation of returns (relative to the benchmark) that the portfolio might experience in the future if its current structure were to remain unaltered. [½] This measure is derived by quantitative modelling techniques and depends on assumptions including:

● the likely future volatility of individual stocks or markets relative to the benchmark [½]

● correlations between different stocks and/or markets. [½] Liability risks [½] Usually determined by carrying out an analysis of experience, eg of the ratio of the actual occurrences of an event to the expected occurrences when the risk was accepted, allowing for the size of the population exposed to risk. [½] Value at risk [½] Value at Risk (VaR) generalises the likelihood of underperforming by providing a statistical measure of downside risk. VaR represents the maximum potential loss on a portfolio over a given future time period with a given degree of confidence. [1] It can be measured either in absolute terms or relative to a benchmark. [½] Expected shortfall (or TailVaR) [½] Expected shortfall is defined to be the expected loss in a portfolio’s value given that the loss is occurring at or below the pth-quantile. [½] It gives the expected value of a portfolio in the worst p% of cases under consideration. [½] It evaluates the value of the portfolio prudently, concentrating on the possible less profitable outcomes. [½] [Maximum 7]

CA1: Assignment X7 Solutions Page 17


● … eg the company may have a tie with a bank that results in lots of business being written, enabling economies of scale and a reduced premium. [½]

● Some categories of business may have a very high expected cost, eg properties in a high risk flood zone and the company may decide not to offer insurance for these categories at all. [½]

● The product may be sold as a loss leader, eg so as to increase the customer base into which other (profitable) products can be sold. [½]

● Pricing simplifications, eg the price may be different to the cost if the premium can be paid monthly but the cost is calculated as an annual amount. [½]

The theoretical value of the claims is subjective and will change over time whereas the price, once set, is fixed. For example, the actuary may reprice the contract within the next month and work out a new theoretical value of the claims! [½] [Maximum 8] Solution X7.8

Comment The Core Reading for this question is covered in Chapter 32, Expenses. (i) Categorisations of expenses and how they might be loaded into premiums Expenses can be categorised as fixed or variable: [½]

● Fixed expenses are those that do not vary with business volumes eg buildings maintenance. [½]

● Variable expenses are those that vary directly with the level of business that is being handled at that time and may be linked to the number of contracts or claims or the amount of premiums/contributions. [½]

Expenses can also be categorised as direct or indirect: [½]

● Direct expenses can be identified as relating directly to a particular class of business. [½]

● Indirect expenses are those that do not relate directly to any class of business. [½]

All variable expenses are direct but fixed expenses can be direct or indirect. [½]

CA1: Assignment X7 Solutions


Expenses can also be categorised according to functionality. [½] For example, by new business, maintenance of existing business (including investment expenses), and termination. [½] The loading for expenses could be:

● a fixed amount per contract

● a percentage of the premium charged

● a combination of the above. [½ each] [Maximum 6] (ii) (a) Expense allocation – sales staff costs This is probably a fixed indirect cost. [½] In terms of function, the sales staff costs will all probably be new business costs. [½] Salaries could be allocated between different classes of business, in proportion to time spent using timesheet analyses. [½] Other (non-salary) staff costs could be allocated to each contract as a fixed amount per new business contract or as a percentage of commission paid. [½] Use of a percentage of commission would imply that there is a bigger staff cost involved in larger cases. This is probably true to a limited extent. [½] (ii)(b) Expense allocation – the cost of a replacement mainframe computer This is an indirect (overhead) cost. There could be some initial allocation between classes of business if only part of the system (relating to particular classes of business) is being replaced. [½] An annual cost would be derived from spreading the cost of the system over its estimated working lifetime. This is called amortisation. [½] The cost could then be allocated between classes of business and functionality in proportion to computer usage, if known. [½] The cost could be allocated to each contract as an amount per contract in force using some reasonable method, eg dividing the total cost by the number of contracts in force. [½]

CA1: Assignment X7 Solutions Page 19


(ii)(c) Expense allocation – the building costs of your new head office Again this is an indirect (overhead) cost. The office will probably be an asset of the company, in which case once the office is built a notional rent would be charged to each department, probably based on the floor space occupied. [1] This could be split between classes of business and functionality in the same proportion as for salaries. [½] The cost could be allocated to each contract as an amount per contract in force using some reasonable method, eg dividing the total cost by the number of contracts in force. [½] [Maximum 6] Solution X7.9

Comment The Core Reading for this question is covered in Chapter 33, Pricing and financing strategies. (i) Financing methods ● Pay-as-you-go – an arrangement under which benefits are paid out of revenue

and no funding is made for future liabilities. [½]

● Smoothed pay-as-you-go – funds that are set up to smooth the costs under a pay-as-you-go approach to allow for the effects of timing differences between contributions and benefits, short-term business cycles and long-term population change. [½]

● Terminal funding – funds that are expected to be sufficient to meet the cost of a series of benefit tranches can be set up as soon the first tranche becomes payable. [½]

● Just-in-time funding – funds that are expected to be sufficient to meet the cost of the benefit can be set up as soon as a risk arises in relation to the future financing of the benefits (eg bankruptcy or change in control). [½]

This method would work in conjunction with another funding method. For example, a terminal funding method may be in place, with the proviso that funds would be set up at an earlier date, if a risk event takes place. [½]

● Regular contributions – funds are gradually built up, to a level expected to be sufficient to meet the cost of the benefit, over the period between the promise being made and the benefit first becoming payable. [½]

CA1: Assignment X7 Solutions


● Lump sum in advance – funds that are expected to be sufficient to meet the cost of the benefit can be set up as soon as the benefit promise is made. [½]

[Maximum 3] (ii) Comparison of methods Security The rate at which the fund is accumulating is the main factor influencing the security offered by the financing method adopted. [½]

● Lump sum in advance funding is the most secure method, since it is the method under which the fund accumulates most quickly. [½]

● Terminal funding gives good security for benefits already in payment but very poor security for those benefits that have not yet started to be paid. [½]

● Regular contributions would provide more security than terminal funding but less security than lump sum in advance funding. [½]

Under all methods of advance funding, the degree of security will depend not only on the timing of the contributions but also the adequacy of contributions. [½] The security offered by advanced funding is subject to:

● the assets of the pensions scheme remaining separate from the sponsors’ other assets ... [½]

● ... so that if the sponsor fails, the assets will not be used to cover other liabilities [½]

● the assets of the pension scheme being invested to achieve an appropriate risk/return balance. [½]

Pay-as-you-go, just-in-time and smoothed pay-as-you-go provide no security in themselves as the sponsor could fail. [½]

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CA1-PU-17 (CMP Upgrade) FINAL (WITHOUT REPLACEMENT PGS) Upgrade/CA1-PU-17.pdf · 2016. 8. 31. · We offer the following tutorials in Subject CA1: • a set of Regular Tutorials (lasting