Subject CA1

Actuarial Risk Management

Core Reading

for the 2016 exams

1 June 2015
Copyright in this Core Reading is the property of the Institute and Faculty of Actuaries who are the
sole distributors.

Core reading is intended for the exclusive use of the purchaser and the Institute and Faculty of
Actuaries do not permit it to be used by another party, copied, electronically transmitted or published
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Legal action will be taken if these terms are infringed. In the case of a member of the Institute and
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Institute and Faculty of Actuaries.

These conditions remain in force after the Core Reading has been superseded by a later edition.
SUBJECT CA1 CORE READING
Contents
Accreditation

Introduction

Unit 1 How to do a professional job

Unit 2 Stakeholders and their needs
Unit 3 Risk environment
Unit 4 Regulatory environment
Unit 5 External environment
Unit 6 Investment environment
Unit 7 Capital requirements
Unit 8 Contract design
Unit 9 Project planning and management
Unit 10 Data
Unit 11 Risk management
Unit 12 Modelling
Unit 13 Assumption setting
Unit 14 Expenses
Unit 15 Developing the cost and the price
Unit 16 Investment management
Unit 17 Provisioning
Unit 18 Relationship between assets and liabilities
Unit 19 Maintaining profitability
Unit 20 Determining the expected results
Unit 21 Reporting actual results
Unit 22 Asset, capital and surplus management
Unit 23 Insolvency and closure
Unit 24 Options and guarantees
Unit 25 Monitoring
Unit 26 Principal terms

Syllabus with cross referencing to Core Reading

SUBJECT CA1 CORE READING
Accreditation
The Institute and Faculty of Actuaries would like to thank the numerous people who have helped in
the development of this material and in the previous versions of Core Reading for aspects of subjects
that now form part of this course.

The following papers and books have been used as the basis for several Units:

Actuarial education in 2002 and beyond: a global perspective. Bellis, C. S.; Felipe, M. Á.
27th International Congress of Actuaries (TICA) (2002) 2: 17-35

The control cycle: financial control of a life assurance company. Goford, J.

Journal of the Institute of Actuaries Students' Society (1985) 28: 99-114

Demystifying capital management in the life assurance industry. Gemmell, J. R.; McAusland, G. S.;
Shah, H. M. et al. SIAS, 2000. 40 pages.

Financial condition assessment. Ryan, J. P.; Archer-Lock, P. R.; Czernuszewicz, A. J. et al.

BAJ (2001) 7(4): 519-603
CORE READING

Introduction
The Core Reading manual has been produced by the Institute and Faculty of Actuaries. The purpose
of the Core Reading is to assist in ensuring that tutors, students and examiners have clear shared
appreciation of the requirements of the syllabus for the qualification examinations for Fellowship of
the Institute and Faculty of Actuaries. The manual supports coverage of the syllabus in helping to
ensure that both depth and breadth are re-enforced.

In examinations students will be expected to demonstrate their understanding of the concepts in Core
Reading; this will be based on the legislation, guidance notes etc. which are in force when the Core
Reading is published, i.e. on 31 May in the year preceding the examinations. Examiners will have
this Core Reading manual when setting the papers. In preparing for examinations students are
recommended to work through past examination questions and will find additional tuition helpful.
The manual will be updated each year to reflect changes in the syllabus, to reflect current practice and
in the interest of clarity.

Examples
The examples in the Core Reading for Core Applications are illustrative only and are not necessarily
complete. The purpose of the examples is to help students develop an understanding of the principles
covered in the Core Reading. Students are not expected to learn the examples as directly examinable
material; however, the examiners may set questions on areas and topics covered in the examples.
2016 How to do a professional job Subject CA1

UNIT 1 — HOW TO DO A PROFESSIONAL JOB

Syllabus objectives

1.1 Describe how actuaries can contribute to meeting the business needs of their clients
and other stakeholders.

1.2 Describe the statutory roles that may be required of actuaries in pensions and
insurance, both in the public and private sectors.

1.3 Outline the professionalism framework of the Institute and Faculty of Actuaries and
the Financial Reporting Council.

1.4 Describe the factors and issues to be taken into account when doing a professional
job.

1.5 Describe the Actuarial Control Cycle and explain the purpose of each of its
components.

1.6 Demonstrate how the Actuarial Control Cycle can be applied in a variety of practical
commercial situations, including its use as a Risk Management Control Cycle.

1 How actuaries can contribute to meeting business needs

Actuaries help stakeholders to identify and analyse the financial risks they face and to
manage and mitigate those risks.

There are many professionals that are active in the fields of risk assessment, management,
mitigation and transfer. Actuarial skills are particularly important for managing risks that
are:

 financial — the risks involved have financial consequences

 in the future — either the risk event or the consequences extends over a period of time

Actuaries need to be able to assess, quantify, manage and monitor the risks inherent in
financial structures, products, schemes, contracts and transactions that provide benefits on
future financial events. In order to do this, they need to be able to:

 Use economic analyses to form judgements about future inflation and interest rates.

 Use data relating to future liabilities to estimate payments that need to be met.

 Build, parameterise, test and implement models.

 Handle assumptions in a critical manner.

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 Build appropriate margins into assumptions and appreciate the impact of such margins.

 Project and discount future cashflows using assumptions.

 Calculate the contributions required to build up a fund over time to meet future
liabilities.

 Monitor the progress of the accumulation of a fund.

 Advise on reinsurance and other risk transfer mechanisms

 Analyse the variation between the actual and expected experience.

 Manage the variation in the progress of a fund to ensure that future liabilities are met.

 Handle data in a critical manner.

 Manage the build up of assets to meet future liabilities.

 Contribute to decisions on investment policies aimed at meeting future liabilities.

As professionals, actuaries have other roles less closely related to risk management and
analysis. An actuary should also be able to:

 Participate with the Government in shaping legislation that affects financial structures,
products, schemes, contract and transactions that provide benefits on future financial
events.

 Work with other professionals to solve problems.

 Understand where and when the expertise of other professionals is needed.

 Operate within an environment that requires professionalism, scrutiny and

transparency in the disclosure of information.

 Apply the highest standards of independence and due diligence to protect the public
interest. There should be no conflict of interest for an actuary in working for a client
and at the same time serving the public interest.

 Communicate the results of all his/her work.

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2 Statutory roles
In some territories there are statutory roles that can only be taken by actuaries. The
statutory roles for actuaries mainly relate to the certification of the adequacy of the
valuation of assets and liabilities for a life insurer, general insurer or pension scheme. The
actuary is usually required to certify some or all of the following:

 In his or her opinion proper records have been kept for the purpose of the valuation of
the liabilities.

 Proper provision for the liabilities has been made.

 The liabilities have been valued in accordance with any legislative rules setting out the
method and assumptions for their valuation.

 The liabilities have been valued in the context of the assets, which in turn have been
valued in accordance with the appropriate rules.

 In his or her opinion the premiums/contributions for future years will be sufficient, on
reasonable actuarial assumptions, and taking into account the free assets of the
provider to enable it to meet its commitments in respect of the contracts written, or
pensions promised.

 A statement of the difference between the value of the provider’s assets and its
liabilities.

 He or she has complied with professional guidance.

In most territories there are statutory bodies that employ actuaries, and in some of these
either the statutory body itself, or a particular actuary employed by it, has a formal role set
out in either primary legislation or secondary regulation.

For example in the UK the Government Actuary (who heads the Government Actuary’s
Department (GAD), part of the civil service) has various responsibilities relating to the
State pension and national insurance schemes. In particular the Government Actuary
provides specialist actuarial advice to government and public services in the UK and
overseas. They are principally concerned with:

 occupational pension schemes

 pensions policy and regulation

 protection for public sector employees’ pension arrangements on the compulsory

transfer of employment to a private sector employer, or to another public sector body

 social security

 the regulation and supervision of insurance companies

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In some territories the regulatory bodies employ actuaries who have specific personal
responsibilities for the supervision of various aspects of insurance companies, benefit
schemes, other providers of financial services and financial intermediaries. Typically a
responsibility might be to monitor the financial strength of such organisations, which
would be coupled with various enforcement powers if a minimum level of financial
strength is not maintained.

An alternative, and increasingly more common, approach is for the regulatory body itself
to have certain objectives, either specific detailed targets or broader general objectives.
The regulators would employ actuaries to carry out much of their work, but such employed
actuaries would not have personal responsibilities set out in legislation.

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.
Professional skills and detailed consideration of the Actuaries’ Code are covered in a two-
day post-qualification 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.

3.2 Technical and ethical standards

These are detailed in Technical Actuarial Standards which set out technical or ethical best
practice and standards for actuaries to follow.

Ethical and professional best practice and standards are the responsibility of the Institute
and Faculty of Actuaries, and apply to all members of the profession, regardless of the
territory or area of work in which they operate. These are referred to as Institute and
Faculty of Actuaries Standards. Institute and Faculty of Actuaries Standards comprise:

 The Actuaries Code

 Institute and Faculty of Actuaries Standards developed since the introduction of the
current professional framework in 2006.

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In the UK, technical actuarial standards are the responsibility of the Financial Reporting
Council (FRC). This is a body that is independent from the Institute and Faculty of
Actuaries. The FRC issues Technical Actuarial Standards (TASs). 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”

Technical Actuarial Standards 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) or pensions
(TAS P), or 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.

3.3 Exercising Judgement — Materiality and Proportionality

The Technical Actuarial Standards are principles based. These principles need to be
considered when carrying out actuarial work that is within the scope of a particular TAS.
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.

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.

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

(i) The principle is not applicable.

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

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

Principles falling in group (i) are mainly matter of fact.

Principles falling in group (ii) and (iii) 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 (iii) then judgement will need to be exercised as to what is
a proportionate application of that principle.

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 mat 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. 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 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.

4 Factors and issues when doing a professional job

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

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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

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

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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. For 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.

4.4 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.

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. These issues are covered in more detail
in Unit 4.

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.

4.5 The task

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?

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 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.

4.6 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?

4.7 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.

4.8 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 (see Section 5).

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4.9 Methodology
The methodology to be used will need to be chosen. If this is not a standard methodology,
then justifications for departing from standard methodologies will need to be given. If it is
not clear to others how the chosen methodology works this may cause problems later when
the results are reviewed and presented.

4.10 Checking the answers

When the answers to the questions have been found they will need to be checked and the
following questions considered:

 Do the answers look reasonable?

 Do the sensitivity tests applied to the answers look reasonable?

 What range of answers is consistent with the level of confidence associated with the
assumptions made?

 Has a peer reviewed the answers?

4.11 Communication of the answers

When communicating the solutions and the options and issues raised in developing them to
the client, the actuary should always be aware who the client is. This may be particularly
difficult where a client has more than one role. For example the trustees of a benefit
scheme may also be representatives of the sponsor of the scheme. The actuary should
make it clear whether the advice is being given to the client as the trustees or as the
representatives of the sponsor.

Communication of the answers in a way that is understood by the client is vital. The
means of communicating the answers must be designed to reflect the way the problem-
owner listens. It is important to check that that the client has fully understood the answers.

The actuary needs to set out the solutions to the client as clearly as possible. Where there
are optional solutions they should be presented in an unbiased fashion avoiding pre-
judgement as to which is the best solution, unless the actuary is asked to make a clear
recommendation.

The background to the solution, the assumptions adopted and any areas of risk and
uncertainty should be clearly presented. However, care should be taken to avoid making
the presentation of this background information so complicated that it becomes confusing
and detracts from the solution.

If any issues arose in the production of the solution which could reduce the effectiveness or
validity of the solution, for example difficulties in obtaining accurate data, the impact of
these issues on the solutions put forward should be made clear to the client.

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In communicating the answers an actuary needs to demonstrate how the answers given
help to provide an optimal solution to the problem. Often the answers will give rise to
more questions or more problems. The client may need to be guided carefully to the
optimal solution. It is important to identify to the client where the original brief ceases and
where further questions are giving rise to additional work (and in some cases additional
fees).

It may also be necessary to give the output a health warning to the effect that the advice is
given for a specific audience and may not be appropriate in other circumstances.

As with any form of communication, the actuary should know the client and the client’s
interests and pitch the language, tone and form of the communication at the appropriate
level.

In reporting the results of an investigation to a client the actuary should take account of any
professional guidance on the content and format of such a report.

4.12 Professional Implications

Throughout any task an actuary needs to consider the professional implications of the work
being done.

The Financial Reporting Council has developed an Actuarial Quality Framework which is
designed to support effective communication between actuaries, their principal clients and
employers such as senior management and members of governing and review bodies, other
professionals such as lawyers and accountants, end-users and their representatives,
policymakers and regulators.

The Framework is intended to be complementary to professional and other regulation

affecting actuaries and those who rely on their work. It aims to promote the following
drivers of actuarial quality:

 Methods: Reliability and usefulness of actuarial methods.

 Communication: Communication of actuarial information and advice.

 Actuaries: Technical skills of actuaries and ethics and professionalism of actuaries.

 Environment: Working environment for actuaries and other factors outside the control
of actuaries

Detailed knowledge of the Actuarial Quality Framework is not required for the
examinations, but the full document can be found by using the search facility on:
http://www.frc.org.uk

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5 The Actuarial Control Cycle

5.1 The actuarial control cycle as a risk management tool
The actuarial control cycle is a model that can be applied to many aspects of actuarial
work. Like all models, it does not necessarily always fit the problem under consideration
at all times or in all circumstances. However, like all good models, it is simple, and it
helps the user to obtain a clearer understanding of the situation.

The actuarial control cycle is a fundamental tool of risk management — the process of
analysing, quantifying, mitigating and monitoring risks, and forms the overall structure of
the bulk of this course.

This involves the following processes.

 Analyse situations, products and projects to determine the risks to which they are
exposed.

 Quantify the financial consequences of the risk events occurring.

 Consider and quantify appropriate methods of managing, mitigating or transferring the

risks.

 Monitor the situation and the risk management procedures implemented as time
develops.

 In the light of experience modify or change the risk management approaches adopted.

The final bullet point above indicates that the process is cyclical. The approach used in
almost all risk management tasks is that of the actuarial control cycle. This is discussed in
detail later in this section.

5.2 Structure of the actuarial control cycle

The actuarial control cycle can be represented diagrammatically, as:

Monitoring the experience Specifying the problem



Developing the solution

Actuarial work usually includes all phases of the cycle. The term “cycle”, and the use of
two-way arrows in the diagram, highlights the importance of monitoring and feedback, and
the inter-relationships between elements of the cycle. In actuarial and risk management
work, the feedback mechanism within the cycle is not an automatic process resulting in a
pre-determined, unconscious adjustment, as happens in some engineering systems. The
feedback mechanism in the actuarial control cycle requires the actuary to exercise personal,
professional judgement.

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Although the underlying problem solving model is completely general, the actuarial
control cycle incorporates the following basic elements, which are common to all actuarial
and risk management work:

 the estimation of the financial impact of uncertain future events

 a long-term rather than short-term horizon
 the recognition of stakeholders’ requirements and risk profiles
 decisions need to be made in the short term in the light of likely future outcomes
 the use of models to represent future financial outcomes
 the use of assumptions based on appropriate historical experience
 the need to allow for the impact of legislation, regulation, taxation, competition
 interpretation of the results of modelling to enable practical strategies to be developed
 monitoring and periodically analysing the emerging experience
 modifying models/strategies in the light of this analysis of the emerging experience

5.3 Purpose of each of the components of the Actuarial Control

Cycle
The central part of the model is based on a simple approach to problem solving — firstly,
define the problem, then design and implement a solution, then monitor the effectiveness
of the solution and revise it if necessary. The actuarial control cycle must of course be
considered in the context of the specific economic and commercial environment in which it
is being used. For example, in a particular scenario it might be necessary to consider
legislation, taxation, and economic trends. In addition the requirements of professionalism
must be recognised at all stages of the cycle.

The following sections discuss the individual components of the actuarial control cycle.

5.4 Specifying the problem

The first stage of the actuarial control cycle is to analyse the risks of the various
stakeholders in detail, and to set out clearly the problem from the point of view of each
stakeholder.

This stage of the control cycle considers the strategic courses of action that could be used
to handle the particular risks in question. It gives an assessment of the risks faced and how
they can be managed, mitigated or transferred. This will reflect the desire of most
institutions to manage their risk both in their core business and in activities incidental to
their core business.

This stage also provides an analysis of the options for the design of plans that transfer risk
from one set of stakeholders to another. These plans provide various benefits, normally in
exchange for a cash premium or contribution. The control cycle can be used as a “sub-
cycle” to determine the prices of the plans.

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5.5 Developing the solution

This stage involves:

 An examination of the major actuarial models currently in use and how they may be
adjusted for the particular problem to be solved.

 Selection of the most appropriate model to use for the problem, or construction of a
new model.

 Consideration and selection of the assumptions to be used in the model. The

assumptions used in a model are critical and it is necessary for the actuary to have a
good understanding of their sensitivities.

 Interpretation of the results of the modelling process.

 Consideration of the implications of the model results on the overall problem.

 Consideration of the implications of the results for all stakeholders.

 Determining a proposed solution to the problem.

 Consideration of alternative solutions and their effects on the problem.

 Formalising a proposal.

5.6 Monitoring the experience

It is critical that the models used are dynamic and reflect current experience where that is
relevant. This stage deals with the monitoring of experience and its feedback into the
problem specification and solution development stages of the control cycle i.e. updating
the investigation.

An important part of this monitoring will be the identification of the causes of any
departure from the targeted outcome from the model and a consideration as to whether
such departures are likely to recur.

5.7 Feedback loops

It is vital that the results of the monitoring process are used. Monitoring might indicate
that the problem was not fully or correctly specified — in other words the solution
developed does not solve the problem that it now appears exists. Alternatively monitoring
might indicate that the solution as developed did not take some vital feature into account.

More usually, the monitoring process indicates that the solution should be refined, perhaps
to bring it up to date, or to reflect current experience, rather than that the solution was not
appropriate. If these results are not fed back into the cycle it is likely that unsatisfactory
consequences for one or more stakeholders will result.

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6 Application of the Actuarial Control Cycle

Each of the common actuarial issues set out below are representative of the practical
problems that arise in the areas in which actuaries work. Solving these problems is likely
to involve the use of techniques and concepts introduced in the Core Technical subjects.
Many of these problems involve the Risk Management Control Cycle. The Risk
Management Control Cycle is covered in more detail in Subject ST9 — Enterprise Risk
Management Specialist Technical.

 Identifying the alternative investment and reinsurance options.

 Asset liability management.

 Defining the level of profit or solvency and future solvency.

 Assessment of the need for capital to protect against the consequences of risk events.

 Assessment of the need for and calculation of provisions.

 Determination of the contributions/premiums required to ensure that benefit promises

payable on future financial events can be met.

 Determination and monitoring of mortality, expense and persistency assumptions for

use within the design of and reserving for contracts or schemes.

 Monitoring the effect of investment mismatching.

Example

A life insurance company is about to enter the annuity market for the first time. It intends
to sell without profits immediate annuities with higher annuities for those lives in ill-
health.

Describe how the actuarial control cycle can be used in the pricing and ongoing financial
management of the product. It is not necessary to discuss how the product might be
administered.

Solution

Specifying the problem

The client will be transferring risk to the insurance company:

 Longevity risk will be transferred, as the annuity will be paid to the client however
long he lives.

 Investment risk (including credit and market risk) will be transferred, as the client will
receive a fixed income, irrespective of market conditions.

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The problem is to determine appropriate premium rates that:

 deliver an acceptable profit to the company

 are competitive in the market place otherwise little business will be written,

bearing in mind that the company is new in the market and has little or no experience of
the product.

Developing the solution

The company will need a pricing (or profit testing) model that can project the future
development of this line of business in various circumstances. The model needs to be
developed or acquired, or an existing model modified.

The first stage in pricing the product is to determine the initial assumptions about future
experience.

The actuary will need to discuss the mortality basis with the underwriter to ensure that the
underwriting decisions are consistent with the pricing basis.

The actuary will need to discuss investment returns and the appropriate matching assets
with the investment managers.

Judgement will need to be applied as to the extent of any margin for prudence included in
the reserving basis. The assumed reserving basis will also be an input to the profit testing
of the product.

As this is a new development, the model will be run several times to test the sensitivity of
premium rates and profit emergence to changes in assumptions. This is important data to
have available for the monitoring stage.

The resultant rates will be compared with those available elsewhere in the market.

Monitoring the experience

After the launch of the annuities the experience will be monitored regularly to determine
how it compares with the assumptions made at launch.

It may take time for significant volumes of data to build up, particularly if mortality
experience is being monitored by type of illness. The smaller the volume of business, the
greater the likely volatility of the experience.

If the experience differs markedly from the initial assumptions then revised assumptions
may be determined. The product will be profit tested once more, which may lead to a
change in premium rates. The experience may also lead to a change in reserving basis.

The experience should be discussed with the underwriters as it may indicate

inconsistencies between the approaches taken by the underwriters and that assumed in the
pricing assumptions.

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Changes to the premium rates offered by competitors will also be monitored to ensure that
the rates do not become uncompetitive. This may also lead to a change in the premium
rates. The monitoring of the ill health enhancements offered by competitors may be
difficult as the approach taken to grouping illnesses may vary significantly between
companies.

It is possible that the company may find that it cannot offer premium rates that are both
competitive and profitable, in which case it may withdraw from the marketplace. If the
rates appear too competitive it may be an indication that the standard mortality assumption
or ratings used are inappropriate, or that the market is not competitive, in which case larger
profits can be made.

END

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2016 Stakeholders and their needs Subject CA1

UNIT 2 — STAKEHOLDERS AND THEIR NEEDS

Syllabus objectives

2.1 Identify the clients that actuaries advise in both the public and private sectors and the
stakeholders affected by that advice.

2.2 Describe how stakeholders other than the client might be affected by any actuarial
advice given.

2.3 Describe the functions of the clients and potential clients that actuaries can and may
advise and the types of advice that actuaries might give to their clients.

2.4 Explain why and how certain factual information about the client should be sought
in order to be able to give advice.

2.5 Explain why subjective attitudes of clients and other stakeholders — especially
towards risk — are relevant to giving advice.

2.6 Distinguish between the responsibility for giving advice and the responsibility for
taking decisions.

2.7 Describe the main providers of benefits on contingent events.

2.8 Describe how products, schemes, contracts and other arrangements can provide
benefits on contingent events which meet the needs of clients and stakeholders.

2.9 Describe the ways of analysing the needs of clients and stakeholders to determine
the appropriate benefits on contingent events to be provided by financial and other
products, schemes, contracts and other arrangements.

1 The clients actuaries advise

There are many clients whom actuaries can advise. In the private sector these include:

 policyholders
 prospective policyholders
 members of benefit schemes and their dependants
 employers
 insurance company — board of directors
 insurance company — shareholders
 insurance company creditors
 trustees of benefit schemes
 sponsors of benefits schemes
 employees
 auditors of insurance companies

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 auditors of the sponsors of benefit schemes

 investment fund managers
 members of investment schemes
 sponsors of capital projects
 banks

In the public sector actuaries advise government departments and related organizations,
such as central banks and regulatory bodies. As in the private sector, advising actuaries
might be employees of the relevant organization, or independent consultants.

2 Other stakeholders affected by actuarial advice given to

clients
It is important to identify all the stakeholders involved when any actuarial advice is given.
In most circumstances different categories of stakeholder have different interests. In the
majority of situations one or more stakeholders will remunerate the actuary, but there will
be a number of other stakeholders with significant interests who do not contribute directly
to the actuary’s remuneration. In many cases the advice given to a client by an actuary will
impact on other stakeholders. The actuary needs to consider the interests of all
stakeholders, and not only those who seek (and pay for) advice.

It is important to consider all stakeholders because omitting a stakeholder will distort the
context e.g. one stakeholder’s risk can be a source of another stakeholder’s gain. It is also
necessary to retain a sense of proportion in considering who else may be affected by advice
given.

The following three scenarios exemplify the range of stakeholders who might be involved
in what initially seems a simple situation.

Where an actuary is advising the board of directors of an insurance company, which is

planning a large expansion in business, that advice may have an impact on:

 The level of benefits that the company’s policyholders receive.

 The level of premium charged to the company’s new and existing policyholders.
 The level of dividend that the shareholders of the insurance company receive.
 The volume of new business the company can write.
 The level of taxes that the Government receives on the profits earned by the company.
 Other insurance companies that are competing in the same market.
 Reinsurance companies through the level of reinsurance business that the company
requires.
 The employees of the insurance company through the employment benefits they
receive.
 Job security for the employees of the insurance company.

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 The work of the regulatory authorities that monitor the insurance company.
 Other insurance companies who may be required by legislation to contribute to a
compensation scheme that pays benefits to the policyholders of insurance companies
that fail.
 Employed sales staff and independent intermediaries.

Where an actuary is advising the trustees on the investment policy for the assets of a
pension scheme that advice can have an impact on:

 the employer who sponsors the scheme

 the providers of capital to the sponsoring employer
 the members of the scheme
 the dependants of the members of the scheme

Where an actuary is advising an insurance company (A) that is taking over another
insurance company (B) that advice can have an impact on:

 the shareholders of (A)

 the shareholders of (B)
 the policyholders of (A)
 the policyholders of (B)
 the employees of (A)
 the employees of (B)
 future policyholders

3 The interests and functions of the clients

The stakeholders listed above have a wide range of interests and functions that actuaries
can provide advice on including:

 Policyholders

– personal protection against death and illness

– protection of property
– investment

 Members of benefit schemes and their dependants

– provision of benefits on future events such as death, retirement, illness, withdrawal

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Subject CA1 Stakeholders and their needs 2016

 Employers

– protection against financial loss arising from the death or ill health of employees
– protection of tangible assets
– protection of intangible assets
– provision of work related benefits that will attract and retain good quality staff
– meeting legislative requirements
– managing the costs of running their business
– quantification of the amount of surplus capital in the business
– investment of surplus capital

 Insurance companies — board of directors

– meeting legislative requirements for the management of the business

– investing and managing the assets of the company
– managing the liabilities of the company
– determining the levels of provisions to hold to meet future liabilities
– setting premium rates
– ensuring that policy proceeds are paid
– meeting policyholders’ reasonable expectations
– meeting the demands of shareholders
– good corporate governance
– obtaining appropriate and adequate reinsurance to protect the business

 Insurance company — shareholders

– obtaining a good return on their investment commensurate with risk

 Insurance company creditors

– certainty that the monies owed to them will be paid

 Trustees of benefit schemes

– managing the assets of the scheme

– paying the benefits promised under the scheme as they fall due
– maintaining solvency

 Sponsors of benefits schemes

– providing protection benefits that meet the needs of the members and their
dependants
– providing retirement benefits that meet the needs of the members
– managing the cost of providing the benefits
– meeting legislative requirements

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 Employees

– provision of protection benefits on death

– provision of pension benefits on retirement
– investment of surplus personal funds

 Auditors of insurance companies

– assessment of long-term liabilities for life insurance companies

– assessment of long-tail claims reserves for general insurers

 Auditors of the sponsors of benefit schemes

– assessment of the future liability to pay benefits

 Government

– setting legislation that impacts on the provision of financial products, schemes,

contracts and transactions that provide benefits on future financial events
– monitoring the adherence to this legislation
– funding benefit provision by the state
– monitoring the funding of benefit provision by the state

 Regulator

– ensuring that regulatory requirements are met

Almost all the above relate to risk transfer of one form or another.

4 Information about the client

Often in their work actuaries are giving advice to a client with a particular problem. Such
advice will often set out alternative solutions and the implications of each solution. These
solutions must always be relevant to the particular circumstances of the client.

In many cases the client will give a brief to, or agree terms of reference with, an actuary
without specifying the client’s particular position. This is normally not because the client
is trying to hide information, but because the client is so knowledgeable about his own
position that he inadvertently thinks everyone else is equally informed.

It is important that before starting analysis of the problem, the actuary is fully briefed about
the client. There will be a significant amount of information in the public domain, for
example information in any company accounts or similar publications. Many clients also
have web sites that contain important information. Before starting on the specific task, the
actuary should research and assimilate such information. This exercise might then require
a follow-up pre-project meeting with the client to ensure that his position has been fully
understood.

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Subject CA1 Stakeholders and their needs 2016

At all times the actuary should be aware of any conflict of interest. An example of when a
conflict of interest could arise is when an actuary is advising both the trustees and the
sponsor of a benefit scheme. The primary concern of the trustees will be the security of
members’ benefits whereas the employer will also be concerned about costs.

5 Attitudes of clients and other stakeholders

5.1 The client
As well as the factual information referred to in the previous section, there is a wealth of
subjective information that the actuary needs to assimilate before giving advice. In
particular, corporate bodies have a risk appetite, which is essentially driven by the risk
appetite of their stakeholders, in particular their owners. Corporate bodies frequently
describe their risk appetite openly in the annual accounts or other published statements.

It is also important for the actuary to be aware of the general style and culture of the client.
This is often best achieved by an initial meeting at the client’s premises, or the opportunity
for a more general discussion with the client in a less formal session than a business
meeting.

5.2 The end customer

Frequently a provider of financial products is required to give advice to its customers. A
provider should seek from customers it advises any information about their circumstances
and objectives which might reasonably be expected to be relevant in enabling it to fulfill its
responsibilities to them. In some jurisdictions this takes the form of an analysis that is part
of a regulated sales process.

A provider should take reasonable steps to give a customer it advises, in a comprehensible

and timely way, any information needed to enable the customer to make a balanced and
informed decision. Providers should similarly be ready to provide customers with a full
and fair account of how they have fulfilled their responsibilities to them.

5.3 Marketing issues

The role of actuaries in the marketing of financial services is to present their results in the
full business context. This means that actuaries need to think through the implications for
all the stakeholders involved. In particular actuaries need to look at the impact on the
customer. This approach will require an actuary to balance conflicting priorities. For
example in saying “we will design a pension scheme so that it gives the best pension
payments”, the meaning of the word “best” will be crucial because it means different
things to pensioners, members with deferred benefits, current members of the scheme
working for the sponsor and future employees of the sponsor. Getting the balance right
between the various stakeholders is very important.

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6 Advice and Decisions

6.1 Types of advice
There are different types of advice that can be given. These include:

 indicative advice — giving an opinion without fully investigating the issues — for
example in response to a direct oral question

 factual advice — based on research of facts e.g. legislation

 recommendations — researched and modelled forecasts, alternatives weighted,

recommendations made consistent with requirements

There will also be occasions when other professionals need to be involved in providing the
advice, such as accountants or lawyers.

The actuary will have made specific assumptions in reaching the advice and
recommendations that are given. The assumptions must also be relevant to the particular
circumstances of the client. Part of the process of advising the client will be to explain the
reasons for making those specific assumptions to the client. The actuary should explain the
implications of making alternative assumptions and of any alternative solutions that may
have been considered but eventually not recommended on both the client and other
stakeholders who may be affected.

However at the end of any discussions it will be the client who decides which solution to
adopt.

An example of where an actuary would only be giving advice would be in the

recommendation of bonus rates on with profit policies to the Board of Directors of an
insurance company in the UK, who will make the final decision on the level of bonuses to
be declared. However, the actuary may have made some implicit decisions in formulating
the advice, for example the grouping of policyholders for the purpose of bonus allocation.
These implicit decisions should be disclosed as part of the process of giving advice.

6.2 Making decisions

Sometimes the actuary may be responsible for making a business decision. An example of
where an actuary may actually make the decision is in the determination of surrender
values under life insurance policies, where the policy wording permits.

Sometimes, an actuary may also have an executive role within an organisation and may be
making decisions on matters such as provisioning, reinsurance programmes, asset
allocation, etc. In such situations there is a danger that the actuary will take decisions
based on his or her own conclusions and the actuary should seek further advice or peer
review of the decision made.

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It is vital that the rationale behind any decisions taken is properly documented, including
documentation of alternatives that have been considered.

7 The main providers of benefits on future contingent events

Benefits for individuals can be provided by:

 the State
 employers or groups of employers
 individuals
 financial institutions or
 other corporations

7.1 The State

The State has a major role in the provision of benefits. This may be through direct
provision, through encouragement of provision or through the regulation of provision from
other providers.

The political, economic and fiscal viewpoints of the State will determine the precise roles
that it will play. However, the roles are likely to fall within the following categories:

 provide benefits to some or all of the population

 educate or require education about the importance of providing for the future

 regulate to encourage or compel benefit provision by or on behalf of some of the

population

 regulate bodies providing benefits, and bodies with custody of funds, in an attempt to
ensure security for promises made, or expectations created

In performing each of these roles, the State should also consider the whole picture to
ensure consistency between the roles.

In countries where life expectancy extends well beyond working age, retirement benefits
are likely to be of high financial significance. Often they are not recognised as such by the
potential recipients. The State is likely to play a large role in ensuring the population
receives or has the opportunity to receive income after retirement.

The extent to which the State makes direct provision, educates the public, compels
provision or encourages provision of non-retirement benefits depends on the perceived
significance and importance to the individuals of the benefits. Benefits to protect
individuals against loss or costs due to long-term ill health or to protect dependants on the
death of an individual are often, however, considered important. The role of the State in
relation to these benefits may, therefore, be very similar to that adopted for retirement
benefits.

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The State can also be the provider of financial instruments through which individuals can
make their own provision for future benefits. For example:

 direct investment in the National Debt (government securities)

 State sponsored savings plans (National Savings in the UK)
 deposits with the State bank, or with local authorities

7.2 Employers
Like the State, employers can play a role in educating and either encouraging or
compelling their employees to plan benefit provision. However, perhaps the most
significant role that can be played by employers is the orderly financing of benefits for
their employees. Such financing may result from:

 compulsion or encouragement from the State

 a desire to look after employees and their dependants financially beyond the level
provided by the State

 a desire to attract and retain the services of good quality employees

 pooling of expenses and expertise

UK surveys indicate that the second point above is the main reason for financing benefits
for employees.

Another role that an employer may play is to provide a facility for the provision of
benefits, i.e. a scheme. This may enable the employer to have greater control over the
benefits being provided and the costs involved. Employer-sponsored pension schemes are
common in many countries.

The financing of a scheme could, subject to legislation, be shared between the employer
and the employees who will receive the benefits. In some cases these schemes are set up
jointly with other employers, often from the same industry, as a means of making provision
more cost effective. This leads to a need for greater care in allocating the liability for
funding defined benefits, particularly in the event of the insolvency of one of the sponsors.
Fund segregation is usually important in reducing such problems.

In some countries employers provide a “flexible benefit” system. Employees have a

choice between, for example, additional salary, additional pension benefits, additional
holiday, enhanced death in service benefits, long-term sickness benefits, etc. Each benefit
is valued, and the employee has a notional sum of money to purchase benefits.

7.3 Individuals
Like employers, the main role that individuals can play in the provision of benefits is in
financing the benefits. This may result from compulsion or encouragement from either the

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State or an employer or a personal desire for larger benefits for themselves or their
dependants than are provided by either the State or an employer.

The financing may be through a formal benefit based scheme, which may be operated by
the State, an employer, an insurer or another financial organisation. Alternatively it may
be by way of non-specific individual savings, or through the accumulation of property.

As an alternative to financing benefits directly for themselves, individuals may group

together and pool their finances. This approach will help to protect the individuals against
some of the uncertainties that may exist in the cost of financing the benefits. It may also
lead to more cost effective provision than if each individual makes their own financial
provision.

A trade union, an employee association, or a religious organisation may be a way in which

individuals can group together to form such a pool. An approach that is common in the
USA is the establishment of retirement communities. These originated as religious
organisations into which members would contribute all their available assets in return for
lifetime care. More recently the idea has developed to provide different levels of
continuing care (including housing) according to the levels of initial and annual
contributions. Continuing Care Retirement Communities (CCRCs) have also started to be
established outside the USA.

In countries, such as the UK, where domestic property tends to be owner-occupied rather
than leased, both the capital value of the home, and also the accumulated equity in it are
important sources of finance for future benefits. To provide finance, loans can be secured
on the accumulated equity in the home. An anticipated capital sum through inheritance of
a domestic property can form a major part in financial planning. However increasing
longevity is a significant risk as it may result in funds not being available at the expected
time.

7.4 Financial Institutions and other corporations

Where an employer and/or an individual is looking to provide benefits of some form they
often do this through products sold by financial institutions such as life insurers, general
insurers, banks, investment houses etc. In some cases the individual is aware of his future
needs and can make plans appropriately. In other cases the institution is pro-active in
drawing the individual's attention to his needs and the consequences of not making
adequate plans.

8 Meeting the needs of stakeholders

8.1 Types of benefits
A whole range of benefits is available, which can be categorised into:

 benefits on events unpredictable in time

 benefits for immediate consumption

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 benefits on events predictable in time

 benefits from the accumulation of disposable income and capital.

Individuals and organisations are often prepared to pay money to another party to protect
themselves against the risk of certain events happening. The main types of financial
products, schemes, contracts and transactions fall into the following categories:

8.2 Insurance contracts

Under insurance contracts, in return for a single payment (or a series of payments) the
provider will pay an individual or his/her heirs an agreed amount (or series of amounts)
that start or end on a pre-specified event. This event may happen to the individual, the
individual’s property or a third party.

8.3 Reinsurance contracts

Providers of financial products, schemes, contracts and transactions can pass some of the
risks that they take on to third parties through reinsurance contracts. Derivatives can also
be used for this purpose.

8.4 Insurance and reinsurance product details

Details of insurance and reinsurance products are given in the appendix to unit 26. This
provides a general indication and example of the types of product that the examiners may
describe in examination questions. The examiners will not be testing detailed knowledge
of the products but will expect candidates to be able to apply their understanding of
principles to both these basic product types and to other products that may exist
independently or where two or more of these basic contract types are combined together as
a package.

8.5 Pension schemes

A pension scheme involves the accumulation of funds, which are paid out on a later event;
usually retirement, but the event may also be death or early withdrawal from the pension
scheme.

8.6 Investment schemes

Investment schemes involve an individual paying a single payment or a series of payments
to a provider with the expectation that a higher amount will be paid back at a later date.

8.7 Derivatives
A derivative is a financial instrument whose value depends on the value of other
investments (e.g. shares, bonds) or variables (e.g. interest rates, exchange rates).

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Subject CA1 Stakeholders and their needs 2016

9 Analysing stakeholders’ needs

It is important to differentiate between the emotional needs and the logical needs of the
customer. If customers’ emotional needs are met then they may get what they want rather
than what they really need. For example, an individual may believe they have a need to
generate additional income in retirement from investment capital. However, this may be
an emotional need. On analysis it may be that the customer’s expenditure levels will fall
on retirement and that the level of additional income required may be very much lower
than perceived.

The logical needs approach involves establishing the customer’s needs, analysing them,
prioritising them and then fitting the benefits or products provided to those needs. Thus
there is reconciliation between the products and the needs. A customer’s logical needs can
be analysed as follows:

 protection e.g. against death, loss, illness, accident

 accumulation for a known purpose e.g. an income in retirement, repayment of a

mortgage

 accumulation for a purpose as yet unknown out of any remaining disposable income or
capital. This may involve taking advantage of any tax-efficient arrangements available

It is also necessary to determine whether the customer’s needs are current or will arise in
the future.

A current need is one that has an immediate effect on the customer’s circumstances. For
example what would happen if they developed a condition that meant they were unlikely to
work again?

A future need may be one that relates to a customer’s future aspirations, for example to
retire at age 55 or to pay off a mortgage at a particular date.

Some needs may be both current and future. For example, for someone in retirement, the
need to maximise returns earned on capital to provide income while at the same time
protecting the value of the capital from the effects of inflation over time is both a current
and future need.

Example

A financial provider believes that it has identified a gap in the market and that it can sell
profitable term and critical illness insurance to financially unsophisticated investors who
have below average disposable income. Describe the features of the target market.

Solution

The features of the target market are that its members are financially unsophisticated and
some will not have access to a bank account. They are likely to have low levels of
disposable income and so little scope to save. They will often have a need for protection

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benefits, but neither need nor can afford large sums insured. Such individuals will not
consider insurance a priority and as a result it will need to be sold to them.

END

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2016 Risk environment Subject CA1

UNIT 3 — RISK ENVIRONMENT

Syllabus objectives

3.1.1 Describe the risk management process for a business that can aid in the design of
products, schemes, contracts and other arrangements to provide benefits on
contingent events.

3.1.2 Describe how risk classification can aid in the design of products, schemes,
contracts and other arrangements that provide benefits on contingent events.

3.1.3 Discuss the difference between systematic and diversifiable risk.

3.1.4 Discuss risk appetite and the attainment of risk efficiency.

3.1.5 Describe credit risk and the use of credit ratings.

3.1.6 Describe liquidity risk.

3.1.7 Describe market risk.

3.1.8 Describe operational risk.

3.1.9 Describe business risk.

3.1.10 Describe attitudes to and methods of risk acceptance, rejection, transfer and
management for stakeholders.

3.1.11 Discuss the portfolio approach to the overall management of risk, including the
use of diversification and avoidance of risk concentrations.

3.1.12 Distinguish between the risks taken as an opportunity for profit and the risks to be
mitigated.

3.1.13 Describe the principle of pooling risks.

3.1.14 Describe the methods of transferring risks.

3.1.15 Describe how enterprise risk management can add value to the management of a
business.

3.1.16 Describe the risks and uncertainties affecting:

 the level and incidence of benefits payable on contingent events

 the overall security of benefits payable on contingent events

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1 The risk management process

1.1 Process
The management of risk by an organisation has three aspects:

 assessing the risks faced

– identification
– measurement/assessment/impact
– financing the risks

 adoption of risk control measures

 monitoring the risk portfolio

Risk identification is the recognition of the risks that can threaten the income and assets of
an organisation. This is the hardest aspect of risk management.

Risk measurement is the estimation of the probability of a risk event occurring and its
likely severity. It gives the basis for evaluating and selecting methods of risk control and
alternative insurance.

Risk financing is the determination of the likely cost of a risk and ensuring that adequate
financial resources are available to cover the risk.

Risk control measures are systems that aim to mitigate the risks or the consequences of
risk events by:
 reducing the probability of a risk occurring (for example, introducing good safety
procedures within a company to reduce the risk of a fire starting)
 limiting the severity of the effects of a risk that does occur (for example, having
sprinkler systems and adequate fire extinguishers, so a fire that does occur can quickly
be put out)
 limiting the financial consequences of a risk that does occur (for example, by a
company having adequate insurance in place to meet the costs of a fire that does
occur).

Risk monitoring is the regular review and re-assessment of all the risks previously
identified, coupled with an overall business review to identify new or previously omitted
risks. It is important to establish a clear management responsibility for each risk in order
that monitoring and control procedures can be effective.

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1.2 Types of risk

RISKS

FINANCIAL NON-FINANCIAL

MARKET CREDIT BUSINESS RISK LIQUIDITY RISK OPERATIONAL RISK EXTERNAL RISK

ASSETS ASSET UNDERWRITING BUSINESS CONTINUITY

LIABILITIES COUNTERPARTY INSURANCE THIRD-PARTY

RISK ADMINISTRATION

ASSET/LIABILITY FINANCING
MATCHING DEBTORS

EXPOSURE

The chart above sets out the risks that a provider of financial products faces irrespective of
the business written. The exact description and importance of each risk and the inter-
relationship between risks depend heavily on the individual circumstances of each
provider. The main risks are described in subsequent sections in this unit.

1.3 Risk control

Risk mitigation techniques are becoming increasingly sophisticated and wide ranging.
Successfully applied they can reduce the expected costs and/or reduce the likelihood of
loss. They can therefore materially impact the profile of any given risk. A risk that gives
rise to serious exposures to the organisation must be a priority candidate for the
application of control techniques.

Some mitigation techniques may simply be a means of putting a plan in place in case the
adverse event happens rather than changing the original risk. This is the approach behind
much disaster recovery planning. However it can also apply to financial risk. For
example a stock market fall of 25% may require selling an entire equity portfolio. If the
risk profile is to be adjusted it must be understood that this is contingent on the policy
being carried out.

Providers need to assess and address risks, arising from all sources, which represent either:

 a material threat to the provider’s business objectives

 an opportunity to exploit the risk and gain a competitive advantage over other
providers

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Through risk management a provider will be able to:

 avoid surprises
 improve the stability and quality of their business
 improve their growth and returns by exploiting risk opportunities
 improve their growth and returns through better management and allocation of capital
 identify opportunities arising from natural synergies
 give stakeholders in their business confidence that the business is well managed
 price products to reflect the inherent level of risk
 improve job security and reduce variability in employee costs
 detect risks earlier meaning they are cheaper and easier to deal with
 determine cost-effective means of risk transfer.

Ideally in the management of risk providers need to look to find the optimal set of
strategies that balance the needs for return, growth and consistency. The risk management
process should:

 incorporate all risks, both financial and non financial

 evaluate all relevant strategies for managing risk, both financial and non financial
 consider all relevant constraints, including political, social, regulatory and competitive
 exploit the hedges and portfolio effects among the risks
 exploit the financial and operational efficiencies within the strategies

Example

A life insurance company plans to launch a regular premium unit-linked pension contract.
The only charge levied under the contract will be an annual amount equal to 1% of the
value of the units.

Discuss the principal risks the company faces in relation to the new pension product.

Solution

The withdrawal rate may be higher than expected. With a large part of the total charges
emerging late in the term of a policy, this would significantly reduce the profitability of
the business. This risk would be particularly acute if the company paid initial commission
under the product that was not recoverable on early termination.

The administration costs may be higher than expected. This would reduce the residual
charges left to recover sales costs and to provide a profit.

The development costs may be higher than expected, making it more difficult to achieve
an acceptable return on the capital invested.

Insufficient new business may be generated to recover the costs incurred when developing
the product. This may be due to various reasons, e.g. unrealistic plans or unfamiliarity of
the existing sales outlets with the new product. To develop adequate sales, the company

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may be intending to move into new distribution channels or target markets. It may assess
the costs of doing this incorrectly.

The average premium size may be lower than expected. With administration costs but not
the charges largely independent of premium size, this would reduce the profitability of the
business.

The demand on capital may be higher than expected, placing a strain on the company’s
ability to finance the business — or reducing the volume of business that can be written.

The company’s investment performance may be poor relative to competitors, reducing the
marketability of the product. In addition, if future investment returns are lower than
expected, the size of the fund-based charge will be less than expected.

Competitors may deliberately undercharge their product to buy market share, forcing the
company to respond or to accept lower levels of new business.

If there is a difference with the company’s current product, greater problems than expected
may be experienced developing new administration systems or training staff in the new
product.

Future legislative change may undermine the product.

The death benefit is not defined. If it is only the bid value of units, mortality is not a
significant risk.

2 Risk classification

Risk classification is a tool for analysing a portfolio of prospective risks by the risk
characteristics, such that each subgroup of risks represents a homogeneous body of risk.
For example prospective policyholders for life assurance can be classified as male/female
or as smoker/non-smoker. Thus the price to be charged for the risk to be covered can be
assessed more accurately. In a design context, the product can be shaped so that it meets
the risks and needs applicable to particular classes of policyholders, eliminating
unnecessary aspects and focusing on coverages that are most pertinent.

For example, the design of a critical illness plan for members of an over-50s association
would start with risk classification. Elements of the standard plan would be discarded as
risk characteristics were analysed. The inclusion of, and pricing for, a children’s rider
benefit may well be deemed inappropriate.

A provider needs to decide which risks it is prepared to:

 take on and keep

 take on but lay off through the use of reinsurance or alternative risk transfers
 refuse

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Having decided on the risks to retain, the provider may change the product design. For
example to avoid a mismatch an investment product may be set up so that the actual
expenses rather than a fixed management charge are deducted from the fund.

Example

A project sponsor has decided to build a small power plant to supply steam and electricity
to a paper mill. The sponsor has asked a bank to lend money to the company that will own
the power plant, once it is built. The project sponsor will operate the plant.

Outline the various ways that the bank may be able to reduce its risk in respect of both
repayment delay and default. Your answer should consider features of both the loan and
the project.

Solution

The risks associated with the project arise from:

 construction risk in the actual building of the power plant

 the terms of the power supply agreement with the paper mill
 the terms of the operating and maintenance agreement with the project sponsor
 the amount of equity held by the owner of the plant
 the amount of subordinated debt held by the owner of the plant

The project risks can be mitigated by:

 Carrying out a full project appraisal, which would include identification and analysis
of the risks involved.

 Requiring the owner to set up a liquidity account containing a minimum of 6 or 12

months interest.

 Risk transfer to sub-contractors, raw material suppliers etc.

 Take out insurance on the risks.

 Share the risk with the owners of the paper mill.

The loan risks can be mitigated by setting terms and conditions on the loan as follows:

 The timing of the loan, pre or post construction.

 Requiring a loan guarantee from the sponsor.

 Requiring a loan guarantee from the builder during the construction period.

 Term of loan — the power plant will have a very long useful life. The lender’s
interest in the project is limited to the term of the loan. In this case, the sponsor is

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likely to have a contract to supply heat and power to the mill for a period of say 10 to
15 years. The sponsor is likely to ask for a loan term equal to the power supply
agreement term.

 Restrictions on further borrowings by the sponsor and owner.

 Setting a principal repayment schedule which is likely to be as fast as the cash flows
will allow for the first say three to five years. It is unlikely that the sponsor will wish
to repay the whole of the debt. Debt is often less expensive than equity.

 Taking a fixed security over all of the assets of the owner.

3 Systematic and diversifiable risk

3.1 Systematic risk
Systematic risk is risk that affects an entire financial market or system, and not just
specific participants. It is not possible to avoid systematic risk through diversification.

In the context of investment markets, the risk of a decline in the market as a whole, with
all stocks being affected is a systematic risk. Assuming that the investor is required to
participate in the market, the risk cannot be avoided. Conversely the risk of a decline in
the value of a particular security can be mitigated by an investor spreading the risk and
investing in a large number of small holdings. A portfolio of 30 to 40 securities in
developed markets such as UK or US (more in case of developing markets because of
higher asset volatilities) will render the portfolio sufficiently diversified to limit exposure
to systematic risk only.

The term systematic risk is sometimes used interchangeably with systemic risk. Systemic
risk is a specific technical term used in finance. Systematic risk has an additional more
general meaning that is “of or pertaining to a system”.

3.2 Diversifiable risk

Diversifiable risk arises from an individual component of a financial market or system.

In the context of investment markets, diversifiable risk occurs when the value of an
individual security falls. A rational investor should not take on any diversifiable risk, as
only non-diversifiable risks are rewarded within the scope of most financial systems.
Therefore, the required return on an asset, that is, the return that compensates for risk
taken, must be linked to its riskiness in a portfolio context — i.e. its contribution to overall
portfolio riskiness — as opposed to its “stand alone riskiness.”.

According to the above theory all rational investors would hold a portfolio of assets that
was as well diversified as possible. If all investors had the same estimates of the relative
risks and returns then they would all hold the same market portfolio. It would be

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impossible to outperform the market except by chance, so only index-tracking funds

would exist.

However, in practice different investors have different estimates of the risks and
returns. As a result they will hold a less well diversified portfolio if they believe that it
offers a sufficiently higher expected return than the market to compensate them for the
diversifiable risks they take. The risk appetite of the investor will affect the extent that
they are prepared to move away from the market portfolio in search of higher returns.

3.3 Risks that are both systematic and diversifiable

Whether a risk is systematic or diversifiable depends on the context. For example an
investment fund that is constrained to invest in domestic equities because of the prospectus
and other information issued to clients, will see the domestic equity market as a systematic
risk. A worldwide equity fund that can invest in domestic and overseas equities will see
exposure to the domestic equity market as a diversifiable risk. Such a fund can hold
investments from a wide range of international markets and thus limit the exposure to any
particular national market.

Example

A life insurance company has written mainly annuity business for the last fifteen years.
The company now considers that its exposure to longevity risk is too great. As annuities
are the company’s main source of new business it does not believe that it can withdraw
from the annuity market without damaging its reputation irreversibly.

Outline ways in which the company can manage its exposure to longevity risk.

Solution

From the point of view of an annuity provider longevity is a systematic risk. Hence its
effects can only be mitigated or transferred.

Mitigation can only be achieved by charging high enough premiums for new risks, and
provisioning adequately for existing risks, so that if longevity increases by more than
expected, the company will have adequate resources to cover the risks. This might
increase premiums to an uncompetitive level and result in loss of business.

Risk transfer can be achieved by passing the risk to a reinsurance company. As the
reinsurer will be able to diversify risks across a large portfolio, then it might be possible
for the reinsurance premium to be lower than the cost of the company itself putting up the
capital. The reinsurer’s own need to cover its expenses and profit requirements will offset
this diversification benefit. Reinsurance also removes the opportunity for the company to
make risk profits as well as protecting it from losses.

As an insurance company, the company has the opportunity to diversify its

mortality/longevity risk by trying to move into other markets with new products. At the
highest level any form of assurance product will diversify some of the annuitant longevity
risk. However for a good match it is necessary to look for products that match the age and

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duration of the annuitant longevity risk. Hence the company should look at the markets
for whole life insurance policies sold to individuals of retirement age. Funeral cost plans
would seem to be a good fit, although the average size is likely to be small, meaning that
large volumes of sales will be necessary for good diversification.

4 Risk appetite/ risk efficiency

4.1 Risk Appetites

Different stakeholders will have different appetites for risk and within a particular class of
stakeholder there will be different appetites for risk. For example one individual may have
a speculative attitude to market risk, while another might be highly cautious. The
speculative individual will be relaxed about investing in emerging markets or highly
geared funds, while the cautious individual would avoid any equity investment at all.

Corporate entities also have different appetites for risk. Frequently the risk appetite is
described in public documents, such as the company’s annual report.

Risk appetite may be linked to other features of the individual or company, such as their
existing exposure to the risk, but it may also be a feature of the culture of the company or
the type of individual. In advising clients, it is important that the actuary has a good
understanding of the client’s risk appetite in all the relevant areas.

4.2 Capital requirements of risk

A person or company that retains any risks, needs to have sufficient capital to cope with
the consequences of the risk event occurring. For individuals, this is almost never the
case. Individuals who do not insure the contents of their houses against flood normally
cannot afford the premium, rather than being in a situation where they sufficient capital to
pay for new furniture after a flood.

For a company, retention of risk necessitates having available capital. For trading
companies the working capital retained in the business is usually considered adequate by
the proprietors, although it frequently isn’t. For financial product providers, regulatory
authorities may impose minimum levels of retained solvency capital derived from a risk
assessment of the business. In the UK, insurance companies are required to hold sufficient
capital to have a resulting ruin probability of 0.5% in one year.

4.3 Markets for risk

The fact that different entities have different appetites for risk enables there to be a market
in risk, and for risk to be transferred between entities with a small appetite to those with a
larger appetite. Almost all financial transactions can be simplified to a transfer of risk
from one entity to another in exchange for a payment of money.

For example an individual is likely to have an appetite for theft of contents from his home
that is lower than the value of the contents that might be stolen. The individual

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consequently pays a premium to an insurance company to transfer the risk to the insurance
company. The insurance company has a greater appetite for the theft risk both because it
is larger, and also because by pooling of risks the company can still have stable returns
and make a profit from the premiums it charges.

Where there is a good market for risk transfer, the system is said to be risk efficient.
Individuals and companies with excess of risk are able to transfer the excess to others who
have less risk than they are prepared to accept. If the market is of adequate size normal
economic factors will result in an efficient market.

5 Credit risk and the use of credit ratings

5.1 Credit risk
In general credit risk is the risk of failure of third parties to repay debts. Particular
examples are:
 The issuer of a corporate bond defaulting on the interest or capital payments. The
term credit risk is sometimes also used to describe the risk associated with any kind of
credit-linked event. This could include changes to credit quality (up or down) or
variations in credit spreads in the market as well as the default events described above.

 Counterparty risk, where one party to a transaction fails to meet their side of the
bargain. An example of counterparty risk is settlement risk, which arises when a party
pays away cash or delivers assets before the counterparty is known to have performed
their part of the deal.

 General debtors — the purchaser of goods and services fails to pay for them.

Certain principles are seen as being fundamental to good lending and in turn to reducing
credit risk. A number of key questions have to be asked:

 Character and ability — is the borrower (and/or its principals) known, competent and
trustworthy? Who introduced them? Can references be obtained? If someone is
found to have lied (or intentionally misled) do not lend. Do key personnel have the
required depth and spread of skills and experience?

 Purpose — to what use will the monies be put? Is the borrower in a sector where there
are concerns, or where the total exposure is already sufficient? Will the lending be
subject to country, currency, environmental, resource, technological, or other inherent
risk? Is the project acceptable on ethical and moral grounds? Are there controls to
ensure that the monies are correctly applied?

 Amount — is the amount to be borrowed reasonable, taking into consideration the

stated purpose and the adequacy of any contribution of the borrower? Who stands to
lose if the project fails?

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 Repayment — can the borrower service and repay the debt when due? How certain is
the source of repayment? What margin of safety has been built into the projections
and assumptions?

Some losses are inevitable, however well regulated the lending process. This needs to be
recognised, and built into the pricing models. The extent to which lending is trouble-free
often depends on the thoroughness of the “due diligence” process undertaken before a
decision to lend is reached.

5.2 Security
Security is a way of enhancing the lender’s position, not an excuse for otherwise bad
lending. The decision as to what security is taken is dependent on:

 the nature of the transaction underlying the borrowing

 the covenant of the borrower
 market circumstances and the comparative negotiating strength of lender and borrower
 what security is available

It must be within the ability of the lender to realise the security if necessary in a cost-
effective manner.

5.3 Credit rating

A credit rating is given to a company’s debt by a credit-rating agency as an indication of
credit worthiness i.e. the likelihood of default/credit loss.

A company may take action to improve its credit rating and these actions may affect the
market for that company’s and other companies’ shares.

Example

Bank A and Bank B are two investment banks operating in highly developed and liquid
bond markets in a country. A and B enter a swap agreement under which A lends cash to
B in return for borrowing fixed interest securities.

Describe the credit and market risks faced by Bank A under the loan agreement, and how
they might be mitigated.

Solution

Bank A has two credit exposures:

In the first, Bank B may default on the termination date and thereby not return the cash in
exchange for the bonds.

In the second, the issuer of the bonds might default during the period of the agreement,
and A would then have no assets to return.

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Bank A faces the risk that the market value of the bonds acquired as security will drop
below the amount of cash lent plus the interest thereon. This risk increases with the
duration of the bonds held as security.

Under the repurchase agreement the lender of cash (Bank A in this case) acquires full title
to the securities handed over as collateral.

The risk is really that the value of the collateral at the time of default is less than the
repurchase price.

That risk is greater for bonds of long duration values than for bonds of short duration.

To mitigate these risks:

 Bank A might insist on short duration bonds.

 If the issuer of the collateral defaults, the lender of cash (Bank A in this case) still has
recourse to the counterparty (Bank B in this case) who must buy the bond back at the
agreed repurchase price. In this case the bond default risk is passed to Bank B.

 Bank A may advance less cash than the market value of the bonds held as security.
This will give Bank A a margin in the event of adverse bond price movements.

 If the value of the bonds falls, Bank B may be required to repay part of the loan
immediately. The position could be reassessed monthly, weekly or even daily. More
frequent reassessment gives greater security to Bank A.

 Bank A could call for replacement security if the existing bonds were to fall
significantly in value because of a default.

 The risk could be reduced by insisting on AAA-rated or AA-rated (depending on the

degree of comfort Bank A is looking for) bonds.

6 Liquidity risk
The normal definition of liquidity risk relates to individuals or companies. Liquidity risk
is the risk that the individual or company, although solvent, does not have sufficient
financial resources available to enable it to meet its obligations as they fall due.

Liquidity pressures are the most common reason why a trading company goes into
liquidation. The phrase “into liquidation” immediately give the reason for the action. A
trading company may well have sufficient assets, probably largely stock and work in
progress, to cover its liabilities, but if those assets cannot be realised, then the company
may not be able to satisfy its creditors, who can force it into liquidation, and possibly to
cease trading.

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Insurance companies and benefit schemes normally have little exposure to liquidity risk,
because a large proportion of their assets are in cash deposits or bond and stock market
assets. In general, these can readily be sold in the market to raise cash when required.

Banks are generally exposed to significant liquidity risk. They lend depositors’ funds and
funds raised from money markets to other organisations, and generally do so for longer
periods than they offer to the providers of the funds. A retail bank that offers customers
instant access to their deposits needs to maintain sufficient liquid resources to withstand a
large number of customers asking for their money back. For this reason banks frequently
offer good investment returns on fixed term deposits, where the depositors are not able to
access their funds until the maturity date.

Similarly, collective investment schemes and insurance funds that invest in real property
need to protect themselves if clients request access to their funds when the underlying
properties cannot be sold. Such funds frequently have the power to defer withdrawals by
up to six months if necessary, to allow time for property sales. Hedge funds that invest in
illiquid assets also often have lock-in periods to mitigate liquidity risk

In the context of financial markets, liquidity risk is where a market does not have the
capacity to handle (at least, without a potential adverse impact on the price) the volume of
an asset to be bought or sold at the time when the deal is required. In general, the larger a
market is, the more liquid it will be, because more participants in the market will be
trading at any one time. Thus when any member of the market wishes to complete a trade,
it is likely that the market will be able to find a counterparty willing to accept the trader.
This particular definition of liquidity is frequently also called marketability.

7 Market risk
Essentially market risks are the risks related to changes in investment market values or
other features correlated with investment markets, such as interest and inflation rates. The
risk can be divided into:

 The consequences of changes on asset values — this is the most obvious implication.
 The consequence of investment market value changes on liabilities.
 The consequences of a provider not matching asset and liability cashflows.

7.1 Asset value changes

Asset value changes can result from:

 Changes in the market values of equities and property. These risks can be systematic
if they occur across the whole market under consideration, but can be diversified in
broad markets by holding a range of assets and asset classes.

 Changes in interest and inflation rates. These primarily affect the value of fixed
interest and index-linked securities, although there is usually a smaller effect on
equities and property.

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7.2 Liability value changes

Liability value changes might arise because promises to stakeholders, policyholders or

benefit scheme members are directly related to investment market values or interest rates.
Alternatively a change in interest or inflation rates might affect the level of provisions a
provider needs to establish for future liabilities. For example a reduction in interest rates
will increase the provisions that a benefit scheme is required to hold to meet its liabilities
for pensions in payment.

7.3 Asset/liability matching

The fundamental principle of investment is that assets should be selected to match the
liabilities in nature, term and currency. If it were possible to find such a perfect match,
then market risk could be completely diversified away by choosing a matched portfolio.

In practice a perfect match may be impossible because:

 there may not be a wide enough range of assets available

 in particular it is unusual for find assets of long enough duration

 liabilities may include options and hence have uncertain cash flows after the option
date

 liabilities may include discretionary benefits

 the cost of maintaining a fully matched portfolio is likely to be prohibitive

Hence even a well matched portfolio is likely to retain some element of risk.

The existence of additional capital gives freedom to intentionally take an unmatched

position in the hope of achieving an additional return. The capital will be used to cover
the cost of the risk taken.

8 Operational risk

Operational risk refers to the risk of loss resulting from inadequate or failed internal
processes, people and systems or from external events. In the UK this is the definition
used by the regulators, the Financial Policy Committee and the Prudential Regulation
Authority

Operational risks can be controlled or mitigated by an organisation. For individuals,

operational risks arise in carrying out their normal lifestyle. For an individual, crossing
the road is an operational risk, which can be mitigated by looking and listening carefully
before crossing.

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Operational risk can arise from:

 inadequate or failed internal processes, people or systems

 the dominance of a single individual over the running of a business, sometimes called
dominance risk

 reliance on third parties to carry out various functions for which the organisation is
responsible

 the failure of plans to recover from an external event

External risk arises from external events, such as storm, fire, flood, or terrorist attack. In
general these are systematic risks. Only for the largest entities is it economically efficient
to diversify these by carrying out the same operation on different sites. However the
failure to arrange mitigation against such risks is an operational risk.

A clear understanding of the business undertaken by a provider and the organisational

structure is a prerequisite to assessing the significance of each risk and how the outcome
of that risk translates into a financial impact on the balance sheet (capital position at any
one point in time) and cash flow (liquidity) requirements. The main effort in the analysis
can then be directed to those key risks.

While it is possible to develop computer models to analyse and price operational risk, such
models are only as good as the parameters input. Whether or not a model is used,
identification of operational risks requires considerable input from owners, senior
management and other individuals who have a detailed working knowledge of the
operations of the business.

9 Business risk

These are specific to the business undertaken. Business risk differs from operational risk
in that the latter are non-financial events that have financial consequences. Examples of
business risk are:

 A life or general insurer not having adequate underwriting standards, and thus taking
on risks at an inadequate price.

 An insurer suffering more claims than anticipated.

 A provider of finance, such as a bank, investing in a business or project that fails to be

successful.

 A reinsurer having greater exposure than planned to a particular risk event — for
example through writing whole account protection covers as well as primary
reinsurance of the risk.

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 A music production company promoting a CD that fails to sell.

 A competitor launching a new product in the week before your similar product launch.

 An umbrella manufacturer whose sales suffer in a drought. Note that it might be

argued that a drought, as an external event, is an operational risk. However the profits
of the company will be so closely correlated with the amount of rainfall that the risk is
key to the company’s business.

Each type of business is exposed to its own particular risks. Those relating to financial
products and financial product providers are covered elsewhere in this course or in other
subjects.

10 Methods of risk acceptance, rejection, transfer and

management

When faced with a risk each stakeholder can choose whether to:

 reject the need for financial coverage of that risk because it is either trivial or largely
diversified

 retain all the risk

 pay a premium to another party to transfer all the risk to that party

 retain some of the risk and pay a premium to transfer the balance of risk to another
party

The stakeholder can also take action to minimise the risk. For example, fitting better locks
can reduce the risk of theft from the home.

The extent to which a stakeholder will choose to pass on all or some of the risk will
depend on several factors:

 how likely the risk event is to happen

 the existing resources that the stakeholder has to meet the cost of the risk event should
it happen

 the amount required by another party to take on that risk.

Example

A house-owner is considering taking out an endowment assurance to repay the capital sum
under a mortgage of £60,000 due in 25 years time. During the term of the loan, interest
payments are made to the lender, but no capital is repaid.

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He first considers:

(a) A regular premium 25-year without profits pure endowment where the only benefit
payable is £60,000 on survival to the maturity date.

He then considers two other products:

(b) A regular premium 25-year with profits endowment assurance where the basic sum
assured is £40,000 payable on death or survival to the maturity date. Regular and
terminal bonuses are payable. In recent years the regular bonus has been a simple
bonus of 3% of the basic sum assured. On death before the maturity date the
minimum benefit payable is guaranteed to be £60,000.

(c) A regular premium 25-year unit-linked endowment assurance where the sum assured
payable on death before the maturity date is £60,000, or the value of units if greater.
On the maturity date the value of units is payable.

(i) Describe the risks avoided and accepted by the investor in opting for product (a) and
mention any insurance products available to overcome the risks accepted.

(ii) Describe the additional risks avoided and accepted by the investor in opting for each
of products (b) and (c) compared with (a).

Solution

(i) For product (a) the main risk avoided is any inability to repay the loan amount at
maturity since the survival benefit is exactly equal to the mortgage amount.

The main risk accepted is the lack of any benefit payable on death or critical illness
before the end of the loan period. This can be overcome by additionally taking out a
term assurance covering the £60,000 on death before 25 years. Critical illness cover
could also be added to the policy.

Depending on the terms of the contract little or no benefit may be available on early
surrender and there is therefore a risk involved if the mortgage is to be repaid early.
This may be avoided if the product does have a benefit payable on early
discontinuance although this is likely to be on worse terms than if the contract
remained in force to maturity.

There is a risk that because of sickness the client cannot afford to pay the premiums.
This could be overcome by including waiver of premium benefit.

(ii) Product (b)

This covers the death risk since the benefit on death is £60,000, or £40,000 plus
bonuses if greater.

An additional risk is accepted because the maturity benefit is only £40,000 plus
bonuses. This may total less than £60,000. This risk might be considered small

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however as a simple bonus of 2% in each of the 25 years will give a maturity value of
£60,000, even without the payment of a terminal bonus. The recent rate of regular
bonus has been 50% higher at 3%.

The product is likely to have a surrender value but, as with product (a), it may be on
unattractive terms.

Product (c)

This covers the death risk since the benefit payable on death is at least equal to the
mortgage amount of £60,000.

An additional risk is accepted however since the maturity benefit is expressed as the
value of units. This could be more or less than £60,000, depending on the investment
performance.

The level of this risk will depend on the level of premium being paid, and whether
there any policy reviews to keep the policy “on track”.

Risk management techniques are covered in more detail in Unit 11 of this course.

11 Risk Portfolios
It is advisable for an individual or company exposed to risk to establish a risk portfolio or
risk register. The risk portfolio categorises the various risks to which the business is
exposed. A categorisation based on the diagram in Section 1 above might be appropriate.

Against each risk would be recorded a quantification of:

 Impact
 Probability

In a simple business the quantification might simply be a subjective assessment of 1 to 5

for each risk. For more complex businesses, risk analysis models may generate a financial
impact figure. As risks are essentially rare events, the probability figure may still be
subjective, but there are some statistics available for historic experience of certain risks
which, appropriately modified, might be used.

The product of the impact and the probability measures give an idea of the relative
importance of the various risks.

The risk portfolio can them 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)

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The risk portfolio can also identify concentrations of risk and highlight the need for
management action in these areas.

12 Risks taken as an opportunity

In financial services, risk is a tradable commodity. Insurance is one of the processes
whereby risk is assessed and priced. If the price at which one party is happy to accept a
risk is less than the perceived cost of the risk to a second party, the opportunity exists for a
risk transfer to the mutual satisfaction of both parties. This is a fundamental rationale for
both insurance and reinsurance.

For a risk to be insurable:

 the policyholder must have an interest in the risk being insured, to distinguish between
insurance and a wager

 a risk must be of a financial and reasonably quantifiable nature

 the amount payable by the insurance policy in the event of a claim must bear some
relationship to the financial loss incurred.
In most countries individuals are deemed to have an unlimited insurable interest in their
own lives and that of any spouse.

It is in the assessment and quantification of risk that the actuary can create opportunities.
This analysis may be taken to a further stage with the recommendation of risk mitigation
processes. A service by which risks are identified and by which procedures are proposed
to manage and control them is further evidence of opportunity arising from the existence
of risk.

Example

A small general insurance company writes only personal lines motor insurance business.

(i) Discuss the areas of risk and uncertainty inherent in the claims experience of this
insurer.

(ii) Describe the other business risks to which this insurer may be exposed.

Solution

(i) Risk and uncertainty will arise both from the outcome of business already written and
in the determination of premiums to charge in future periods.

Claims

Motor insurance claims are subject to wide variability in amount. As the insurer is
small, there is uncertainty as to whether changes in claims costs year on year are due
to changes in the underlying risk or merely random variation.

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Variability will also exist in terms of frequency, incidence and cost of handling
claims.

Delays from occurrence to notification, and from reporting to settlement result in

uncertainty regarding the ultimate cost of claims.

Changes in cover

If cover is added or deleted from the motor policies there probably won’t be
sufficient data to make a reliable estimate of the impact of the change.

Characteristics of policyholders

If the company is aiming to attract different risks to those it has historically held the
claims experience may differ from the past. It is difficult to determine how the
claims will change. There may be opportunities for anti-selection if the premium
rates do not reflect the risk across the range of business written correctly. If the
majority of contracts issued are those where the rates are inadequate, this anti-
selection will result in losses.

Attitude to claims

Experience from the USA suggests that policyholders are starting to claim for events
they would not have done previously. Society is becoming increasingly litigious.

Crime/fraud rate

As this increases, claims for accidental damage and theft may increase. The timing of
any increasing crime rate is uncertain. This will be correlated to other economic
indicators.

Judicial decisions

This is often referred to as “court award” inflation. Precedents will be set involving
new types of claim eligible for compensation and how much the settlements for them
are. Occasionally a new level of awards is set for existing types of claim. This will
immediately increase the average amount at which all future claims are settled.
Sometimes these decisions will be retrospective meaning that the uplift applies to all
outstanding claims as well as future ones.

Legislation

There may be fiscal changes in tax, the cost of cars or the cost of repairs. There may
be changes in cover, for example the removal of the upper limit on compensation or
the introduction of a requirement to pay hospital charges etc. There may be a change
in law, for example a restriction on the factors that can be used in underwriting.

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Catastrophe

A flood or hurricane could lead to many claims (for example from trees falling on
cars during a hurricane).

Currency risks

Paying claims in other territories exposes the company to the risks of fluctuating
currencies and currency mismatching if reserves are not held in other currencies.

Reinsurance

This is subject to uncertainty as:

 the company may inadequately appreciate the scale of the risks and purchase
inadequate reinsurance

 it may have doubts about the value for money and availability of reinsurance

 the ability to make a recovery will depend on the solvency position of the
reinsurer

Policy wording

This must be precise so the only claims paid are those that the company intended to
provide cover for. Similarly the wording on reinsurance contracts must be precise so
that the company can recover what it expects to.

Inflation

Uncertainty about future inflation especially for bodily injury claims will affect the
actual profit made and hence the assessment of premium required to provide cover in
future periods.

(ii) This insurer may be exposed to the following business risks:

 Competition:

– the products may be inferior

– the prices may be uncompetitive
– the insurer may have fallen behind in the use of technology and so gained
less business
– prices may be too cheap, leading to unsatisfactory financial performance
– the business is affected by changes in legislation which others have allowed
for
– if business is lost then costs will rise as fixed expenses still have to be
recouped

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 Underwriting standards — new vehicle types or construction methods may be

underwritten incorrectly.

 As this is a small company it could be geographically exposed by writing a lot of

business near its head office. This could lead to an aggregation of claims from a
weather event in the area.

 Underwriting cycle. As the insurer only writes motor business there is no

opportunity to cross subsidise with classes at different stages of the cycle. As
profits increase insurers enter the market, buy market share with low premiums,
market premiums decrease until losses are made. Insurers leave the market,
prices increase and the market edges back into profitability. As this insurer only
writes one class, at the bottom of the cycle they will either lose business, which
will put pressure on fixed expenses or they will have to charge lower premiums
which will decrease the solvency position.

13 The principle of pooling risks

Insurers and reinsurers take on risks in return for a premium because in doing so they can
combine or pool many risks together, which means that there is greater certainty in the
future payments they are likely to have to make on the occurrence of an insured event.

Ideally risk events need to meet the following criteria if they are to be insurable, as the law
of large numbers mean that these will help the insurer reduce the volatility of the risk
profile they hold:

 Individual risk events should be independent of each other.

 The probability of the event should be relatively small. In other words, an event that
is nearly certain to occur is not conducive to insurance on the face of it, death is
certain, so a whole life assurance does not fit within the above criterion. However the
considerable uncertainty over timing still gives rise to an insurable event.

 Large numbers of potentially similar risks should be pooled in order to reduce the
variance and hence achieve more certainty.

 There should be an ultimate limit on the liability undertaken by the insurer.

 Moral hazards should be eliminated as far as possible because these are difficult to
quantify.

 There should be sufficient existing statistical data/information to enable the insurer to

estimate the extent of the risk and its likelihood of occurrence.

However, the desire to write business means that an insurer may be found to provide cover
when these ideal criteria are not met.

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14 Methods of transferring risk

14.1 Reinsurance
Reinsurance is a way of reducing, or removing, some of the risks. The reinsurer will wish
to make a profit from the risks it takes on. Effectively part of the profit from the business
is passed to the reinsurer. A decision must be made which balances risks against the costs
of mitigating them.

There are a variety of ways in which the liabilities arising under a contract can be re-
insured. Some types of reinsurance completely remove a risk from the provider. Many
others leave the liability with the provider but provide a payment to the provider that is
aimed at covering that liability. However, even if a liability is fully matched by a
reinsurance arrangement, the provider still bears the risk that the reinsurer is unable to
fulfil its obligations.
In assessing risks and rewards, the actuary can place a realistic estimate on the value of the
benefits that would be paid by the reinsurance provider. This is likely to be lower than the
cost of the reinsurance, as the reinsurance premium will include loadings for profits and
contingencies.

Values will also need to be placed on the range of likely benefit costs so that an
assessment of the risk can be made in comparison to the cost of the reinsurance.

Another factor to note in assessing the relative costs of retaining the risk or buying
reinsurance is that the reinsurer may be able to offer very competitive terms for
administration, actuarial services and other insurance advice if a reinsurance contract is
purchased. There is therefore often a financial advantage to many small providers in
obtaining reinsurance.

In addition to the relative costs and the variability of those costs, the liquidity risk of
retaining the risk or buying reinsurance also needs to be considered in making a decision.
For example the purchase of annuities by a pension scheme may in itself create a liquidity
risk for the pension scheme. The purchase of cover for death in service lump sums will,
however, remove a potentially significant liquidity risk. This may be particularly
important for a pension scheme that is immature or small, as the investment income may
be low relative to the death benefits.

Example

A medium-sized general insurance company writes only personal motor business. The
company is developing a model that can be used to test the impact on profitability and
solvency of changing its reinsurance cover. The existing reinsurance programme has for
the last 5 years consisted of quota share reinsurance and individual excess of loss
reinsurance.

(i) Discuss the factors that the company should consider when deciding upon an
appropriate reinsurance programme.

(ii) Describe how the model would be constructed.

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Solution

(i) The factors that should be considered when deciding upon an appropriate
reinsurance programme for this company include:

 Stability of profits: more excess of loss protection (i.e. lower excess point) may
result in more stable results and stability of profits will affect ability to pay
stable dividends (which shareholders may prefer).

 Management and shareholders’ attitude to risk.

 The size of the company’s free reserves and the extent to which these can
withstand adverse large loss experience.

 The potential for accumulations of claims, does the business that the company
writes mean that there is too much exposure in one geographical area?
Individual excess of loss will not address this and so the company may decide
that it needs more quota share in order to write a wider range of risks but
maintain similar levels of net exposure.

 Statutory solvency: how will changing the reinsurance protection impact any
statutory solvency position?

 Company strategy: is the company expecting to expand its business? How

much of a strain will this place on the free reserves?

 Technical assistance: does the company benefit from technical help from
existing reinsurers? How will a change in the reinsurance programme affect this
arrangement?

 Market reputation: how will investors, analysts, brokers and customers react to
any significant change in reinsurance programme?

 Security status: reinsurers with better security may charge more for the cover.

 Value for money of reinsurance available in the market.

(ii) The model should project cashflows over a 5 to 10 year period. By varying the
retention level for the excess of loss reinsurance and the proportion reinsured for the
quota share, the model can be used to determine the effect of the excess of loss
reinsurance on profitability and statutory solvency. Projections need to be realistic
so the assumptions used must be on best estimate basis. The future gross claims
expected should be determined using individual claims data for the last 5 to 10
years, gross of reinsurance. These should be adjusted for:

 claims inflation

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 changes to policy terms and conditions (e.g. changes to claims definitions, cover
provided, the amount of any loss met by the policyholder)

 changes to the cover provided

 changes to deductibles (policy excesses)

 external factors

 changes to claims handling or settlement costs etc.

Claims frequency and amount distributions should be modelled separately so that

trends can be spotted in either. For a sensible retention level, a combined claims
distribution function should be derived from the separate claims frequency and
amount distributions. Expenses and investment cashflows should also be modelled.
The reinsurance premiums likely to be charged for excess of loss cover with various
excess points should be investigated. These reinsurance premiums should be
compared with modelled reinsurance recoveries expected at different excess points.

14.2 Alternative risk transfer

There is no wholly accepted definition of Alternative Risk Transfer (ART). One definition
is anything that is not traditional insurance or reinsurance. ART often uses both banking
and insurance techniques. It produces tailor-made solutions for risks that the conventional
market would regard as uninsurable.

There are many types of ART contract, common varieties include:

 Integrated risk covers

These are typically arranged between insurers and reinsurers. They can be used as a
substitute for debt or equity in the investment portfolio of the original insurer. They
are used to:

– avoid buying excessive cover

– smooth results
– lock into attractive terms

They are often written as multi-year, multi-line covers and will give premium savings
due to cost savings and to greater stability of results over longer time periods and
across more (uncorrelated) lines.

 Securitisation

This is the transfer of insurance risk to the banking and capital markets. Among other
things it is used for managing risks associated with catastrophes, as the financial
markets are large and should be capable of absorbing catastrophe risk. The rationale is
that insurance catastrophe risk is not correlated with market (systematic) risk and so

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there is a benefit to investors. The banking and capital markets are used because of
capacity issues and because the risks involved are ones with which the banking and
capital markets are more comfortable. To date the pricing of such contracts has been
similar to that for traditional catastrophe reinsurance and much more expensive than
similarly rated corporate bonds.

 Post loss funding

This guarantees that in exchange for a commitment fee funding will be provided on
the occurrence of a specific loss. The funding is often a loan on pre-arranged terms or
equity. The commitment fee will be lower than the equivalent insurance cost (because
the cost of the funding will in the most part be borne after the event has happened).
Thus before the loss happens the contract appears cheaper than conventional
insurance.

 Insurance derivatives

For example catastrophe or weather options.

 Swaps

Organisations with matching, but negatively correlated risks can swap packages of
risk so that each organisation has a greater risk diversification. For example a
reinsurer with exposure to Japanese earthquakes may swap some of this risk with a
reinsurer with exposure to hurricanes in Florida.

Swaps can also be set up between non-insurance organisations with opposite risks.
For example energy companies dislike warm weather as consumers use less of their
product, conversely household insurers dislike cold weather as it leads to insurance
claims. The two organisations can however, swap their risks.

Reasons why providers take out ART contracts include:

 provision of cover that might otherwise be unavailable

 stabilisation of results
 cheaper cover
 tax advantages
 greater security of payment
 management of solvency margins
 more effective provision of risk management
 as a source of capital

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15 Enterprise risk management

All but the simplest businesses comprise a number of business units. These units might:

 carry out the same activity but in different locations

 carry out different activities at the same location
 carry out different activities at different locations
 operate in different countries
 operate in different markets
 be separate companies in a group, which each have their own business units

The largest multinational companies may comprise business units that carry out
completely unrelated activities.

One approach to risk management would be for the parent company to determine its
overall risk appetite and to divide this up among the business units. Just as each business
unit has its own management team to run its business, the business unit management team
manages the risks of the business within the risk appetite they have been allocated.

As risk analysis involves allocation of capital to support the risks retained by each
business unit, this approach is likely to mean that the group is not making best use of its
available capital.

It is clear that this approach makes no allowance for the benefits of diversification or
pooling of risks. A crude approach to allow for diversification would be simply to allow
the risk appetites allocated to the business units to add up to perhaps 130% or 150% of the
group’s overall risk appetite.

A preferable approach is to establish the group risk management function as a major

activity at the enterprise level. The group can then impose similar risk assessment
procedures on the various business units, which will enable the results from the various
models to be combined into a risk assessment model at the entity level. In turn this will
give the group management insight into the areas with resulting undiversified risk
exposures where the risks need to be transferred or capital set against them. This will be
an important feed into the business planning and capital allocation cycles.

Such an approach to risk management will enable the company to take advantage of
opportunities to enhance value, i.e. if they understand their risks better, they can use them
to their advantage by taking greater (educated) risks in order to increase returns.
Enterprise Risk Management is not just about reducing risk – it is also about a company
putting itself into a better position to be able to take advantage of strategic risk-based
opportunities.

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16 Risks and uncertainties affecting benefit payments

Where there is a delay between a benefit being promised and that benefit being provided,
there will always be some uncertainty for the sponsor, the provider, the recipient, or all
three. This uncertainty may relate to the level or the incidence of the benefits, or to the
level or the incidence of the contributions/premiums required to pay for those benefits.
Attached to the uncertainty is a risk for the potential beneficiary that the benefits will be
less valuable than expected or that they will not be received at the expected (or required)
time. There is also a risk for the sponsor or provider that costs will be greater than
expected or that payments will be required at an inopportune time.

In circumstances where there is no uncertainty about the level or incidence of the benefits
or contributions, there may still be risks, to some of the parties involved, that these certain
amounts have been adversely affected by inflation.

There may be a risk for the State that it is expected to put right any losses that the public
incurs. This is particularly relevant if the State provides means-tested benefits, for
example a minimum income level in retirement. If an individual believes that the
minimum income level is sufficient for all his needs, he would be better advised to spend
surplus funds on improving his immediate lifestyle. If the surplus funds were invested to
provide a future income, this income might simply reduce the sum that the State would
provide by exactly the same amount. The individual would forgo immediate consumption
for no increase in income later.

16.1 Benefits

16.1.1 Known in advance

Where the benefits are pre-defined, perhaps the greatest risk for a potential beneficiary is
that there are insufficient funds available to provide the promised benefit. This may be as
a result of:

 insufficient funds having been set aside, i.e. underfunding

 the insolvency of a sponsor or provider of the benefits
 the holding of investments which are not matched to the liabilities
 or a combination of these events

A separate risk is that the funds, although sufficient, are not available when they are
required to finance the benefit. This illiquidity may arise when assets have been set aside
to fund the benefits, but it is more likely to occur if no separate assets exist.

There may be a further risk that a benefit promise is changed or is changeable within the
terms of the contract. In the case of non-State provision of benefits, legislation will
usually prevent a worsening of benefits that relate to past periods, unless the beneficiary
agrees to the change. However, some types of contract, for example critical illness
contracts, may have definitions of an insured event that is not guaranteed throughout the
term of the contract. Changes to benefits provided by the State may be more easily
introduced.

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Where funds are sufficient and liquid, and the level and incidence of benefits is exactly as
promised, the beneficiaries are still exposed to the risk that these promised benefits do not
meet their needs. This may be as a result of a failure to recognise this when the benefit
promise was made, or it may be a result of inflation eroding the value of the benefits.

16.1.2 Unknown in advance

Where benefits are not fully defined, but are instead linked in some way to the funds
available and investment conditions, there is further uncertainty, and hence risk, for the
beneficiary that the level of the benefits will be lower than expected if the investment
return is lower than had been anticipated, or if any expense charges deducted are higher
than was expected.

The level of the benefits will also be reduced if the terms of purchase for any investment
vehicles are worse than had been anticipated. For example, if an annuity were to be
purchased to provide a retirement pension, the level of the pension would be dependent on
the terms on which an annuity could be purchased. The level of annuity that could be
purchased will also be heavily dependent on the market value of investments on the day
that the annuity is purchased. Risks therefore exist to the extent that the annuity rates do
not change as often as market values and more particularly to the extent that the
investments held prior to vesting differ from those underlying the annuities.

However, the risk may remain with the provider of the savings contract, under which the
funds for purchasing an annuity have been accumulated, if there are guaranteed annuity
rates that provide higher benefits than could be bought in the market.

Again, there is a risk that inflation or a failure to recognise benefit needs when planning
provision leads to benefits that do not meet the beneficiaries’ true needs. The risk relating
to inflation could be viewed as the risk of reduced purchasing power due to growth in
price inflation, or it could be viewed as a risk of reduced relative standard of living due to
investment returns failing to keep pace with general earnings growth.

For non-life insurance policies there is also the risk that the payment on an insured event
happening is much higher than was anticipated when the policy was written. This could
happen when inflationary increases in the value of the insured property are higher than
general inflation, or when the courts award higher than anticipated levels of compensation
for insured events.

16.2 Contributions/premiums

16.2.1 Known in advance

If the contributions/premiums are pre-defined, uncertainties exist about the capacity to

pay, i.e. the extent that these contributions/premiums relate to the wealth/solvency of the
party paying them in real terms.

Contributions/premiums that are defined in real rather than monetary terms will create a
risk that the inflationary factor to which they are linked increases at a rate greater than that

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anticipated, or greater than any growth in those earnings from which the contributions are
to be made.

But if contributions are fixed, there is the risk that the resultant benefits are different from
those expected.

16.2.2 Unknown in advance

If benefits, rather than contributions/premiums, are defined, it will not be possible to be

certain about the level of contributions required until all benefits have been provided and
no future liabilities exist. The overall level of the contributions required will depend on:

 the amount of the promised benefit

 the probability of individuals being eligible to accrue the benefits

 the probability of individuals being eligible to receive the benefits

 the effect of inflation on the level, or the real level, of the benefits

 the investment return achieved on the contributions (net of tax and expenses, if
appropriate)

To the extent that liquid funds are not set aside in advance of benefits being provided, the
above factors will also lead to uncertainty about the incidence of contributions.

Other uncertainties relating to the incidence of contributions result from the extent to
which the value of any funds set aside do not equal the value of funds that are expected to
be required to cover future benefit payments. For example, if it is thought that the funds
set aside will not be sufficient to meet the benefits for which they were intended,
additional funds will be required. These funds could then in theory be provided at any
point in time before the benefits need to be provided. However, in practice there may
either be legislative or self-imposed constraints on the timing of these contributions or the
sponsor may become insolvent.

One legislative approach is to require that the values of assets and liabilities are regularly
assessed and compared, with corrective action being required if the assets are not
sufficient. For example, in some countries a minimum capital requirements must be held
in addition to the value of the liabilities.

Any requirement to make good any shortfall by payment of extra contributions clearly
creates a risk that the sponsor/provider has insufficient liquid funds to do so. If re-
assessments are frequent, changes in contributions are likely to be of manageable size

A further risk that may result from excessive contributions/premiums is that the
sponsor/provider itself may become insolvent. This may affect a beneficiary’s total
income more than the loss of insecure benefit promises. There may be a balance to be
struck if the employer is the sponsor of the benefits.

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If contributions/premiums are pre-defined but there is a minimum guarantee applying to

the level of benefits, the sponsor/provider will incur extra costs, which will arise if the
guarantees ever apply. To reduce the extent of these risks for a sponsor/provider who
meets the balance of the cost, the cost of any guarantees should be taken into account in
setting the defined contributions and the investment strategy.

There is also the risk that if the sponsor/provider is taken over by a third party the new
owner may not be willing to continue to sponsor/provide the benefits.

16.3 Risks to contributions/premiums and benefits

Whether contributions/premiums are defined or not there are a number of other factors that
may lead to uncertainty of the contributions/premiums required. These are:

 loss of funds due to fraud or misappropriation

 incorrect benefit payments
 inappropriate advice
 administrative costs, especially as a result of compliance with changes in legislation
 decisions by parties to whom power has been delegated
 fines or removal of tax status resulting from non-compliance with legislative
requirements
 changes to tax rates or status

There may also be personal risks, such as jail or disqualification from office, for directors
or trustees.

Any guarantees provided by the sponsor/provider reduce uncertainties for the

beneficiaries. However, they lead to an uncertainty for the sponsor/provider because of
the risk of the guarantees becoming relevant and causing an increase in costs. The benefits
of guarantees and the costs of meeting them is an important feedback loop into the
actuarial control cycle.

Whether benefits are defined or not, there are some factors that lead to uncertainty of the
benefits to be received by beneficiaries. These are:

 default by sponsor/provider at a time when the funds held are insufficient

 default by sponsor/provider when funds held include loans to the sponsor/provider

 failure by sponsor/provider to pay contributions/premiums in a timely manner

 takeover of the sponsor/provider by an organisation unwilling to continue to meet

benefit promises

 decision by the sponsor/provider that benefits will be reduced

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 inadequate communication by sponsor/provider with beneficiaries, of the strength of

the sponsor, provider, guarantee, promise etc., giving rise to complaints and possible
compensation to some beneficiaries and shortfall for others.

General economic mismanagement by a sponsor/provider of assets and liabilities may also

lead to a risk of a benefit shortfall.

Inappropriate advice may result from:

 incompetence or insufficient experience of the advisor

 lack of integrity of the advisor, perhaps due to sales related payments
 the use of an unsuitable model or parameters
 errors in the data relating to the beneficiaries
 State-encouraged but inappropriate actions
 over complicated products

A major example of the risks of inappropriate advice arose in the UK in relation to the
mis-selling of personal pension policies to individuals who had better provision through an
employer-sponsored arrangement. This is thought to have been caused by a combination
of some of the above factors.

Another example of inappropriate advice could be changes in the investment or benefit

provider, where the costs involved in switching outweighs the gains from having what
may well be a better investment, provider or form of provision.

16.4 Return on investments

Where premiums/contributions are set aside before the relevant benefits become payable,
they will need to be invested. Depending on the way in which the arrangement is
designed, the return on the investments may affect the level of benefits, the level of
contributions, or both. The incidence of the return on investments may also in some
circumstances affect the incidence of benefits and/or contributions. The characteristics of
the main types of investment asset are dealt with in unit 6.

For some types of investment, the income will be defined. If this is in monetary terms,
there will be no uncertainty about the level of the income, provided that the borrower does
not default, but there will be uncertainty about its value relative to any inflation linked
benefit outgo. If the income is defined in real terms, there will be uncertainty about the
absolute level of the income but less uncertainty about the level relative to any benefit
outgo expressed in real terms. The degree of uncertainty will depend on whether the
indexation of the income is consistent with the inflation that applies to the benefits.

Similarly, some types of investment provide defined levels of capital on defined dates or
ranges of dates. Again, the level may be certain in monetary or real terms and so
uncertainties similar to those for income may exist.

Other types of investment do not provide any capital redemption and so capital can only
be redeemed by sale of the investment on the open market. The level of capital that will

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be received is therefore totally dependent on the investment conditions at the time of sale
and depends on there being a willing buyer for the investment.

To the extent that investment proceeds, whether income or capital, exceeds the short-term
benefit outgo there will be a need to re-invest those proceeds. This creates the risk that the
investment conditions at the time will result in higher prices than previously anticipated
and so lower expectations for future investment returns.
There is a similar risk in relation to the investment of future contributions/premiums that
are not required to meet immediate benefit outgo.

16.5 Tax and expenses

The overall level of investment return is net of any taxation and expenses. There are
therefore risks associated with changes in taxation and increases in expense levels.

16.6 Appreciation of benefits by recipients

Where benefits are provided in an attempt to meet the needs and desires of the
beneficiaries, by someone other than the beneficiaries themselves, there is a risk that the
perception of those needs and desires are not consistent with the views of those
beneficiaries. If the beneficiaries do not appreciate the benefits, it could be thought that
the capital used to provide the benefits has not been put to the best use and so the non-
financial return on the capital has been poor.

16.7 Security
The overall security of benefits is related to all of the factors that affect the uncertainty of
benefits, contributions and investment returns. The security is affected to the extent that a
need for extra contributions, for whatever reason, is not met immediately.

There may also be risks to overall security that result from errors in determining the
contribution/premium requirements. Such errors may be a result of:

 the use of an unsuitable model

 the use of unsuitable parameters
 errors in any data used to determine parameters for the models
 errors in the data relating to the beneficiaries

16.8 Strength of the sponsor/provider promise

The strength of the promise by the sponsor/provider and the impact of the asset allocation
on the ability to meet promises made in adverse circumstances should be communicated to
the beneficiaries.

END

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2016 Regulatory environment Subject CA1

UNIT 4 — REGULATORY ENVIRONMENT

Syllabus objectives

3.2.1 Describe the principles and aims of prudential and market conduct regulatory
regimes.

3.2.2 Explain the concept of information asymmetry.

3.2.3 Explain how certain features of financial contracts might be identified as unfair.

3.2.4 Discuss the implications of a requirement to treat the customer fairly.

1 The principles and aims of market conduct regulatory

regimes
1.1 The aims of regulation
The extent and form of the regulation of any market is sometimes a controversial matter
and this is certainly true of financial markets. However, the financial markets of all
developed economies are regulated to a greater or lesser extent. The principal aims of
regulation are:

 to correct perceived market inefficiencies and to promote efficient and orderly markets
 to protect consumers of financial products
 to maintain confidence in the financial system
 to help reduce financial crime

These aims are, of course, related.

Regulation has a cost. Regulators must attempt to develop a system that can achieve the
aims specified above at minimum cost and hope that the benefits, which are difficult to
measure, outweigh the costs. Direct costs arise in administering the regulation and in
compliance for the regulated firms. Other economic costs of regulation have been claimed
to arise from:

 an alteration in the behaviour of consumers, who may be given a false sense of

security and a reduced sense of responsibility for their own actions

 an undermining of the sense of professional responsibility amongst intermediaries and

advisors

 a reduction in consumer protection mechanisms developed by the market itself

 reduced product innovation

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 reduced competition

As financial markets become more and more globalised, regulators are having to co-
ordinate their activities on an international basis.

It is often claimed that the need for regulation of financial markets is greater than the need
for regulation of most other markets for two reasons. The first is the importance of
confidence in the financial system, the dangers of problems in one area spreading to other
parts of the system, and the damage that would be done by a systemic financial collapse.
To prevent systemic collapse or loss of confidence it is not necessary to guarantee the
solvency of every financial institution but merely to ensure that the failure of one
participant does not threaten the whole system.

The second reason for the importance of regulating financial markets is the asymmetry of
information between the product provider and the end customer. This is discussed in
section 2 of his unit.

1.2 Areas in which regulation is required

The main functions of a regulator are typically:

 influencing and reviewing government policy

 vetting and registration of firms and individuals authorised to conduct certain types of
business

 supervising the prudential management of financial organisations and the way in

which they conduct their business

 enforcing regulations, investigating suspected breaches and imposing sanctions

 providing information to consumers and the public

For practical purposes, regulation may be segregated by type of financial business such as
insurance or investment. It will be necessary to regulate deposit taking institutions,
financial intermediaries, securities markets, professional advisers and non-financial
companies offering securities to the public.

A key aspect to protecting consumers and reducing systematic risk is that institutions must
hold sufficient capital to cover their liabilities. Ensuring this requires that accurate models
of the business are in place to monitor risk levels and that they are used with competence
and integrity. Indeed, ensuring the competence and integrity of financial practitioners and
managers is a crucial role for a financial regulator. Individuals may have to prove their
competence by obtaining specified qualifications or membership of a professional
organisation. Regulators may also be able to prevent an individual working in a particular
industry or at a senior level if they are not judged to be a “fit and proper” person.
Regulators may establish compensation schemes, funded either by the industry or by
government, which provide recompense to investors who have suffered losses. These

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typically cover losses due to fraud, bad advice or failure of the service provider rather than
market related losses.

Security market regulators will seek to ensure that the market is transparent, orderly and
provides proper protection to investors. Companies listed on a stock exchange will have
to fulfil certain criteria regarding financial stability and will need to fulfil specified
obligations for the disclosure of financial and other information. Regulators will monitor
aspects such as the prices at which business is done and the reporting of deals. There are
likely to be regulations governing issues of new shares and take-over bids for companies.

1.3 Possible regulatory regimes

Regulation can take many forms. It can be prescriptive, with detailed rules setting out
what may or may not be done. Alternatively, it can involve freedom of action but with
rules on publicity so that third parties are fully informed about the providers of financial
services. Finally, the regime can allow freedom of action but prescribe the outcomes that
will be tolerated.

1.3.1 Unregulated markets and unregulated lines of business

It has been argued that the costs of regulation in some markets outweigh the benefits.
Examples might be markets where only professionals operate or commodity products with
guaranteed benefits that are sold only on price, such as term assurance.

1.3.2 Voluntary codes of conduct

These operate effectively in many circumstances but are vulnerable to a lack of public
confidence or to a few “rogue” operators refusing to co-operate, leading to a breakdown of
the system.

1.3.3 Self-regulation

A self-regulatory system is organised and operated by the participants in a particular

market without government intervention. The incentive to do so is the fact that regulation
is an economic good that consumers of financial services are willing to pay for and which
will benefit all participants. An alternative incentive is the threat by government to
impose statutory regulation if a satisfactory self-regulatory system isn’t implemented.

An advantage of self-regulation is that the system is implemented by the people with the
greatest knowledge of the market, who also have the greatest incentive to achieve the
optimal cost benefit ratio. Self-regulation should, in theory, be able to respond rapidly to
changes in market needs. Also, it may be easier to persuade firms and individuals to co-
operate with a self-regulatory organisation than with a government bureaucracy.

The main problem with self-regulation is the closeness of the regulator to the industry it is
regulating. There is a danger that the regulator accepts the industry’s point of view and is
less in tune with the views of third parties. This can lead to a weaker regime than is
acceptable to consumers and other members of the public. Even if the regulatory regime is

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operating efficiently and effectively it can suffer from low public confidence in the
system.

Self-regulatory organisations may also inhibit new entrants to a market.

1.3.4 Statutory regulation

In statutory regulation the government sets out the rules and polices them. This has the
advantage that it should be less open to abuse than the alternatives and may command a
higher degree of public confidence. Also, the regulatory body may be able to be run
efficiently if, for example, economies of scale can be achieved through grouping its
activities by function rather than type of business.

The disadvantages of statutory regulation are that it can be more costly and inflexible than
self- regulation. It is argued that the market participants themselves are in the best
position to devise and run the regulatory system. Outsiders may impose rules that are
unnecessarily costly and may not achieve the desired aim. It is claimed that attempts by
government to improve market efficiency usually fail and that financial services regulation
is an economic good that is best developed by the market.

1.3.5 Mixed regimes

In practice many regulatory regimes are a mixture of all of the systems described above,
with codes of practice, self-regulation, and statutory regulation all operating in parallel.
Even a regime that is self-regulatory in name is likely to have statutory aspects.
Regulations are often developed by market driven private institutions (such as stock
exchanges) as well as by governments.

An important source of the benefits aimed at by regulators, is the professional

responsibility of market practitioners and intermediaries themselves. Professional bodies,
such as the Faculty & Institute of Actuaries, with responsibility for ensuring that their
members are appropriately qualified for the work they undertake and that they conform to
professional standards of behaviour have a long history of ensuring market stability and
consumer protection.

2 Information asymmetry
Information asymmetry is the situation where at least one party to a transaction has
relevant information which the other party or parties do not have.

One example of information asymmetry leads to anti selection. If a contract has an option
that can be exercised by the policyholder or benefit scheme member, it is more likely that
the option will be exercised by an individual who would find it most beneficial. For
example:

 Insurability options, where an individual can increase the level of life cover without
supplying medical evidence, are more likely to be exercised by lives in poor health.

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Lives in good health may find it cheaper just to buy a new policy, subject to full
underwriting.

 Individuals in normal health are more likely to exercise guaranteed annuity rate
options that are attached to their pension fund at the point of retirement. Even if the
guaranteed rates are in the money for lives in normal health, lives with health
impairments may be able to purchase an impaired life annuity at a better rate.

Another source of information asymmetry is where a prospective policyholder tries to

avoid divulging information to a product provider. For example an individual who
believes that special terms for a contract might be imposed were a medical examination
required might propose for a sum assured just below the limit that would trigger an
automatic medical examination, and not answer questions on a proposal truthfully. This is
an example of fraud.

However the area of information asymmetry that is of most concern to regulators is the
asymmetry of information between the product provider and the end customer. There is a
difference in expertise and negotiating strength that often exists in financial transactions,
particularly in retail markets. This is made more significant by the fact that financial
transactions related to investment, insurance and pensions have a significant impact on the
future economic welfare of individuals. Furthermore in most countries the majority of the
population is not well educated in financial matters, and find the range of solutions offered
to their needs complex and confusing.

Information asymmetry can be reduced or mitigated by requirements for a service provider

to disclose full information about its products or itself in an understandable form and
perhaps by consumer education by the regulator. Knowledge held by a service provider
about third parties can be restricted to that which is publicly available by insider-trading
regulations and by techniques such as “Chinese walls” or separation of functions between
different organisations.

The weakness of an individual in negotiating a deal with a large institution may be

addressed by price controls or the regulation of selling practices. The customer’s position
can be strengthened by devices such as giving them the right to terminate the sales process
at any time, or by providing a “cooling off” period, during which a consumer can cancel a
contract with no penalty.

3 Unfair features of insurance contracts

In all retail financial products the legal contract document is written by the product
provider. Financial product providers have great expertise in designing contracts, and
legal teams that ensure the contract wording is in their favour. The retail customer has
none of these advantages. Hence in many countries there is consumer protection
legislation that provides for unfair terms in insurance contracts to be set aside.

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Example

A general insurance company writes unemployment insurance in connection with a

finance house. The finance house offers loans for the purchase of motor vehicles,
typically over three years. The unemployment insurance is paid by a single premium
which is added to the amount borrowed. If the policyholder is unemployed for a period of
eight weeks, the insurance policy will pay an amount equal to the remaining sum
outstanding on the loan (but not any arrears of repayments).

If the borrower repays the loan early, the unemployment cover will cease and the insurer
will pay a surrender value of the policy to the finance house, which will be credited to the
loan account in determining the final repayment balance due. If the policyholder cancels
the unemployment cover without repaying the loan, no surrender value is paid.

When a surrender value is paid it is calculated as:

P * 0.55 * t / n

Where: P is the single premium paid

n is the original term of the policy in months
t is the number of complete months left to run

Discuss whether the surrender value calculation and the terms under which a surrender
value is paid are fair to the policyholder.

Solution

The surrender value formula is a straight line run off starting at 55% of the original
premium. The insurance company will have incurred initial expenses in setting the policy
up and in paying commission to the intermediary — in this case the finance house. Thus it
is reasonable for the scale not to start at 100%

The amount outstanding under the loan will reduce as repayments are made. Thus more of
the net single premium (after expenses and commission) is required for the early months
of cover than the later months, when the outstanding loan will be small. Theoretically the
surrender value formula should be a concave curve. But a straight line of best fit through
the curve is easy to understand. It will pay surrender values that are too low at early
durations and too high at later durations.

Overall the surrender value basis is not unreasonable.

It is also reasonable that the surrender value is paid to the finance house, provided that it is
clearly credited to the policyholder’s account. This is likely to save the insurer
administrative costs, and thus should keep the premium rates down.

What is unreasonable is that there is no surrender value if the policyholder decides that he
does not want the unemployment cover without repaying the loan. The policyholder has a
contract with the insurer, with the finance house only being an intermediary. The
policyholder’s circumstances may have changed, and the cover not be required. If the

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insurer was prepared to pay a surrender value when its risk terminated for one reason, the
same value should be available for any cause of termination. This contract term is unfair
to the policyholder.

4 Treating the customer fairly

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 a general regulatory
requirement on regulated bodies to treat their customers 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.

These conflicts are exacerbated by the fact that in many cases financial products and
schemes have benefits or charges that can be varied at the discretion of the product
provider. It is generally accepted that discretionary benefits and charges should not be too
dissimilar from those customers were led to believe that they would receive when they
entered into the contract or transaction.

There is no precise method of defining what customers were led to believe at the inception
of a contract, but it is generally accepted that the main influences on policyholder
expectations are:

 statements made by the provider, especially those made to the client in marketing
literature and other communications

 the past practice of the provider

 the general practices of other providers in the market

END

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UNIT 5 — EXTERNAL ENVIRONMENT

Syllabus objectives

3.3 Describe the implications for the main providers of benefits on contingent events
of:

 legislation — regulations
 State benefits
 tax
 accounting standards
 capital adequacy and solvency
 corporate governance
 risk management requirements
 competitive advantage
 commercial requirements
 changing cultural and social trends
 demographic changes
 environmental issues
 lifestyle considerations
 international practice
 technological changes

1 External environment
It is important to bear in mind the external environment when framing actuarial advice.
The following sections look at some aspects of the external environment which can have
implications for the main providers of benefits on future financial events. The issues
identified are not intended to be exhaustive. Actuaries frequently have to interpret these
broad aspects in a specific, and frequently unfamiliar situation. This usually requires
general knowledge, business awareness and a considerable measure of common sense.

2 Legislation and regulations

In some countries there are forms of insurance which are compulsory. There is legislation
which requires certain individuals or organisations to hold them. Examples include:

 employers’ liability insurance

 motor third party liability insurance

Regulations may influence the type of financial product most suited to a consumer’s needs
when there are a number of otherwise acceptable products. For example limitations on
charges for certain types of collective investment scheme may make that type of contract
more suitable than another without the charge limitation, even though there are other
disadvantageous features.

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The regulation of the sales process for different types of product may influence the types
of product that are brought to market by product providers. Requirements for detailed
explanation to consumers of complex benefit smoothing processes or derivative
investment strategies may mean that they are not marketed however suitable they might be
for consumers’ needs.

3 State benefits
Where the state provides benefits to its citizens these are often at a low level which may
only be sufficient to keep individuals just out of poverty. Many individuals will want have
a higher level of benefit. An employer may provide this through a retirement benefits
scheme or membership of a private health arrangement. Alternatively the individual may
wish to provide personal benefits either through saving or through the purchase of
insurance.

State benefits should be taken into account when considering the financial planning needs
of an individual. There are two aspects to this:

 Individuals may need to provide less for themselves. For example in the UK where
emergency hospital treatment is free very few individuals would want to take
insurance out against this, but they may take out private medical insurance against the
need to have other treatment such as a hip replacement or dental care. As another
example an employer sponsoring a benefit scheme may allow for any benefit provided
by the state when considering the total benefit needed by its employees and as a result
provide less from its scheme.

 Where State benefits are means tested, individuals on a low income who only have a
limited ability to save may find that it is better value for them not to save at all, as any
savings they have will be offset against the benefits that they are entitled to from the
State and result in a lower level of income. For example the amount of long term care
or housing benefit provided by the state may be reduced for those with assets worth
more than a certain value.

An example of significant state involvement in controlling benefit provision is Singapore’s

Central Provident Fund. This was set up in 1955 to provide financial security for workers
in their retirement or when they were no longer able to work. It requires compulsory
contributions from employees and employers. It has evolved, since 1955, into a
comprehensive social security savings scheme, which not only covers members retirement
needs but also their needs for:

 home ownership
 healthcare
 education of their children
 financial protection through insurance

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If the State requires individuals to save for their retirement or other benefits this will
reduce the amount that individuals feel they can or need to invest in individual
arrangements.

4 Tax
The tax treatment of benefits can also have an impact on the needs of individuals. For
example in the UK part of an individual’s private or employer sponsored pension benefits
can be taken as a tax-free lump sum (sometimes by the commutation of pension for cash).
Almost 100% of those retiring take the lump sum even if they then use it to purchase an
annuity, as they will pay less tax on the annuity than they would if they took the benefit as
pension rather than cash.

Tax may also need to be considered when considering what inheritance an individual will
pass on. For example if tax is payable on the individual’s estate on death it may be
possible to take out insurance to cover this tax liability.

The impact of tax on savings should also be considered. For example in the UK both the
amount saved towards retirement (within limits) and the investment return on the
accumulating fund for pensions products are tax-free but the retirement proceeds are taxed
as income. An alternative form of saving, in the UK, is an Individual Savings Account
(ISA) where the amount saved comes from taxed income but the investment return and
ultimate proceeds are tax-free. The marginal tax rate of the individual should be
considered when deciding which is the most appropriate form of saving.

Example

In a certain country the only tax levied on providers of financial products is a premium
tax. A percentage of each premium received by the product provider is paid to the
government.

(i) State the advantages and disadvantages of this method of taxation from the
perspective of the company and the government.

(ii) State other practical ways of taxing the business of financial providers.

Solution

(i) The advantages of this method are that the tax is:

 simple to calculate
 easy to collect
 hard to avoid, this is a disadvantage for the providers!
 easy to build into premium calculations

Also there will not be any distortions between different types of business if the tax is
universal.

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The disadvantages of this method are:

 A high profile front-end tax on savings may be commercially and politically

unpopular.

 The amount of tax collected will not increase if the profits of providers increase,
this is an advantage for the providers.

 If the tax were not applied to the whole premium (e.g. to avoid taxing any
savings element) a company would have freedom to manipulate the notional
premium split in order to minimize the tax due, removing all the advantages of
simplicity.

 It may conflict with other government objectives (e.g. encouraging individuals

to fund their pensions privately).

(ii) Other possible ways of taxing the business of financial providers:

 A tax on profits (i.e. change in value of assets less change in value of liabilities).

 To tax investment income, possibly with some sort of relief for management
expenses.

 A tax on realised capital gains, possibly with some allowance for inflation over
the period held.

 A tax on unrealised capital gains.

 A tax on policy proceeds (possibly tax excess over premiums paid).

 Tax policy proceeds only in the event of non-contractual termination.

 Depending how policy proceeds are taxed, tax relief might be given on
premiums.

 Include policy values as assets and subject to a wealth tax.

5 Accounting standards
The way that benefits need to be reported in company accounts may influence the types of
benefits that employers are prepared to provide for their employees.

The presentation of financial instruments in the accounts of product providers also impacts
on the range of products that is brought to market. For example, the different accounting
requirements for setting the provisions for different types of insurance contract in different
territories can influence the design of contracts. Similarly whether a fund manager brings
investments to market within an insurance wrapper through a subsidiary company, or

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through a unit trust or mutual fund might depend on the presentation and results shown in
the company’s accounts.

6 Capital adequacy and solvency

Capital adequacy and solvency form part of banking and insurance regulation which sets a
framework on how financial institutions measure their capital adequacy and solvency.
Capital requirements for financial product providers are discussed in more detail in Unit 7.

Internationally, the Basel Committee on Banking Supervision influences the capital

requirements imposed on banks by the regulatory authorities in different countries. This is
done through a complex capital adequacy framework commonly known as Basel II. A
bank’s capital ratio is the percentage of its capital to its risk-weighted assets. The weights
applied to the assets are defined by risk-sensitivity ratios the method of calculating these is
set out in Basel II accord.

7 Corporate governance
Corporate governance refers to the high level framework within which managerial
decisions are made in a company. The aim of good corporate governance is that a
company should be managed in order to best meet appropriate requirements of its
stakeholders — the shareholders, employees, pensioners, customers, suppliers and others
who may be affected by the company’s operations whilst not having any contractual
relationship with the company at any time.

One particular concern of attempts to create good corporate governance is that

management might make decisions based more on their own personal interests than on
those of relevant stakeholders.

Good corporate governance can be enhanced by ensuring that remuneration incentivises

management to act in the interests of stakeholders. Share options maybe seen as part of
this, though the lack of sufficient downside for management can limit how well share
options perform this function. Non-executive directors are also often part of a structure
aimed at good corporate governance.

The governance arrangements of the product provider have a major influence on the ways
in which stakeholder needs are addressed. Product providers might be mutual societies or
proprietary companies, and the latter might be private or public companies. For
proprietary life insurance companies the apportionment of surpluses between with profit
policyholders and shareholders is also important.

Mutual societies have no shareholders and profits belong entirely to policyholders. On the
face of it mutuals should be able to provide better benefits for the same cost than
proprietaries, because no funds are diverted to provide a dividend stream to shareholders.
The disadvantage of mutuality is that finance cannot readily be raised from capital markets
by the usual methods. This is likely to restrict the products that a mutual might be

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prepared to offer. In particular products that are capital intensive will be less attractive to
the mutual and may be priced accordingly.

Mutuals may offer specific distributions of surplus to their members. With profits
insurance companies, friendly societies and co-operative organisations tend to do this. The
alternative is to design products with the lowest margins in the price consistent with the
risks undertaken and benefit members by that route.

Public proprietary companies benefit from easier access to capital markets for finance, and
may also have greater economies of scale and more dynamic management than mutuals.
These benefits may pay for the dividends to shareholders themselves, and the company
may have a competitive edge over the mutual. Private companies are as restricted as
mutuals for raising capital, but often benefit from the close involvement of the owners,
which is a management advantage.

Guidance on corporate governance is often developed by private institutions as well as by

governments. For example, in the UK, the Financial Reporting Council has issued a Code
of Practice on corporate governance.

8 Risk management requirements

In corporate finance, risk management requirements are concerned with the measuring,
monitoring and controlling of the risk on a firm’s balance sheet. This particularly applies
to banking and insurance companies where regulators are responsible for establishing
safeguards to protect against a systematic failure of the system and the economy. The
regulations in many countries are based on the Basel II framework which categorises risks
as follows:

 market risk
 credit risk
 operational risk

and specifies methods for calculating capital requirements to cover each of these risks.

9 Competitive advantage and commercial requirements

A consequence of the competitive nature of the insurance business is what is known as the
underwriting cycle. Profitability in the various insurance classes tends to go in cycles,
which are driven by market forces of supply and demand.

When business is profitable, more insurers enter the market. Premium rates will reduce as
insurers compete for market share. This will lead to reduced profits or to losses, and the
cycle will go into depression. The position may be accentuated by catastrophes or by the
economic climate.

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At the bottom of the cycle, insurers will leave that market or reduce their involvement in
the classes concerned, as premiums are too low to be profitable. Eventually premium rates
will increase to cover the losses being incurred. The speed with which this occurs will
depend on the position adopted by the leading insurers in that business, and insurers’
continuing demand for market share.

In the long term, the pattern of profits and losses should even out. In the short term,
profitable classes may be able to cross-subsidise losses in other classes.

More extremely, however, the inability to make profits at the bottom of the underwriting
cycle could lead to:

 loss of business, putting pressure on the ability to recoup fixed expenses and future
growth prospects

 a reduced solvency position, requiring additional capital support or other remedial

action

The position of a class of business in the underwriting cycle is, therefore, an important
consideration when making strategic decisions.

10 Changing cultural and social trends

Changing cultural and social trends can have an impact on the financial products, schemes,
contracts and transactions available. For example:

 As home ownership becomes more widespread in the population there will be a

greater demand for mortgages.

 If the State cuts back on healthcare provision for its citizens there will be a greater
demand for products that meet the cost of private healthcare.

 If individuals have increased amounts of “spare” income there may be an increased

demand for savings products.

 In many countries, for motor insurance business, there has been an increase in the use
of telematics, whereby to better assess the risk factors for an individual, the
policyholder’s driving behaviour and other factors are monitored through a black box
device, installed in the insured vehicle, or through a smart phone app. This makes
some risk factors such as:

 the ability of the driver

 the speed at which the vehicle is usually driven and its general level of
performance

which would not normally be easily measurable, measurable and the results can be
used to help price the motor insurance policy.

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11 Demographic changes
Demographic changes to a population can have a major impact on the main providers of
benefits on contingent events — particularly the State. There are two main sources of
demographic changes leading to population ageing:

 rising life expectancy and

 declining fertility.

The significant decline in the total fertility rate over the last 50 years is primarily
responsible for the population ageing that is taking place in the world’s most developed
countries. Many developing countries are going through faster fertility transitions and
they will experience even faster population ageing than the currently developed countries
in the future.

The effects of an ageing population are considerable:

 Economically, older people are more likely to be saving money and less likely to be
spending it. This leads to lower interest rates and deflationary pressures on economies

 Social welfare systems have also begun to experience problems. Some pay-as-you-go
state pension systems are becoming almost completely unsustainable.

 The cost of healthcare systems will increase dramatically as populations age.

Governments will be faced with a choice between requiring higher levels of tax to be
paid or accepting reduced government role in providing health care.

 However, the second largest area of expenditure for many governments is education.
The cost of educating the population will tend to fall with an ageing population.

12 Environmental issues
Government, advocacy groups and the actual preferences of individual participants in
investment markets have acted to ensure that the concern felt by the public on the
environment and ethical issues impacts the behaviour of financial markets.

Providers that want to be attractive to the widest possible range of investors will want to
be attractive to investors for whom environmental and ethical issues are part of the
investment process and decision making.

Operators of savings products (insurers, asset managers) have promoted products that aim
to enhance the effect of the investment process on environmental and ethical issues.
Products are sold which have a “socially responsible overlay” and the investment
managers commit to engaging in a constructive dialogue with company management to
promote environmental and ethical objectives.

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The environmental impact of the way providers communicate with the public may also
need to be considered. For example, some mutual organisations that have demutualised
have been criticised for the large amounts of paper used in sending information about the
demutualisation process to their members.

13 Lifestyle considerations
Younger members of the population will have a high demand for loans and mortgages and
are less likely to be saving towards retirement.

As individuals age they will pay off some of their loans and begin to save. They may also
have an increased demand for life insurance protection products as they have dependent
children.

Older members of the population are likely to reduce the amount they save and once they
retire from employment start spending the funds they have saved. They may have a need
for annuities and products providing long term care. Their need for life insurance may
decline, as their dependants become more self-sufficient.

As people live longer they will need to save more and/or save for longer to ensure that
their assets do not run out before they die.

14 International practice
Providers may need to look to the international market to see if products sold in other
countries could be replicated in their own. Often the difference in tax and legislative
requirements between other countries and the providers’ own country make this difficult.
However, one example of a product that has been imported to the UK from Australia is a
mortgage product under which the homeowner can offset any monies they have in current
and savings accounts against the capital they owe on their mortgage loan. Interest is
usually calculated daily and charged on the balance of the difference between the loan and
any savings or cash in the borrower’s current account. Repayment of the loan capital is
also flexible with the borrower choosing how much to repay each month. Another
example is critical illness cover, which was developed in South Africa.

15 Technological changes
The ways in which financial products are provided for individuals has changed
significantly over recent years following wider use of the internet.

For example:

 Insurance and individual pension products used to be mainly sold by insurance

intermediaries who would aim to find the best contact in terms of benefits and
premiums for their client. Now, many of these products are sold over the internet with

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clients being able to obtain a range of quotations for themselves. Using a credit card,
clients can purchase the product without ever speaking to a representative of the
provider.

 Banking and saving services are also now provided over the internet and by telephone
as well as in the traditional bank and building society branches.

END

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UNIT 6 — INVESTMENT ENVIRONMENT

Syllabus objectives

3.4.1 Discuss the cashflows of simple financial arrangements and the need to invest
appropriately to provide for financial benefits on contingent events.

3.4.2 Demonstrate a knowledge and understanding of the characteristics of the principal

investment assets and of the markets in such assets.

3.4.3 Explain the principal economic influences on investment markets.

3.4.4 Describe the main features of the behaviour of market price levels and total returns
and discuss their relationships to each other.

3.4.5 Discuss the theoretical and historical relationships between the total returns, and
the components of total returns, on equities, bonds, cash and price and earnings
inflation.

1 Cashflows
1.1 Matching cashflows
The means by which providers deliver benefits is through the investment of assets. A key
decision for the provider is whether or not to invest in such a way that the expected
cashflows from the assets held match the expected cash flows from the liabilities it has
taken on.

If the decision is taken to match the assets to the liabilities then the optimal matched
position will need to be determined. Given the uncertainties in the future cashflows of
different liabilities, and the possible uncertainties associated with some assets, this is not a
trivial exercise. Methods based on financial economics and corporate finance theory can
be used to meet this aim and are considered later in this course.

If the decision is taken not to match the assets to the liabilities then additional capital will
need to be held to cover the possibility that there are insufficient assets to meet the
liabilities when they fall due. Again, the determination of how much extra capital will be
needed is not trivial.

The practical work of the actuary usually involves the assessment and projection of future
cash flows. These are simply sums of money, which are paid or received at different
times. Both the timing and the amount of the cash flows may be known or unknown.

For example, a company operating a privately owned bridge, road or tunnel will receive
toll payments. The company will pay out money for maintenance, debt repayment and for
other management expenses. From the company’s viewpoint the toll payments are
positive cash flows (i.e. money received) while the maintenance, debt repayments and

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other expenses are negative cash flows (i.e. money paid out). Similar cash flows arise in
all businesses. In some businesses, such as insurance companies, positive cash flows
(premiums) are received before negative cash flows (claims and expenses) arise. These
are available for investment, and will generate investment income, which is in turn another
positive cash flow.

Where there is uncertainty about the amount or timing of cash flows, one actuarial
technique is to assign probabilities to both the amount and the existence of a cash flow.

1.2 Examples of cash flow scenarios

In this section some simple examples are given of practical situations that are readily
described by cash flow models. In the examination candidates may be required to
consider features of other examples of cashflow models.

1.2.1 An annuity

An annuity provides a series of regular payments in return for a single premium. The
conditions under which the annuity payments will be made will be clearly specified.

For an immediate annuity, payments are made as long as the annuitant is alive. The cash
flows for the investor will be an initial negative cash flow, for the purchase of the annuity,
followed by a series of smaller regular positive cash flows throughout his lifetime.

From the perspective of the annuity provider, there is an initial positive cash flow followed
by an unknown number of regular known negative cash flows. These cash flows will
comprise not only the annuity instalments, but also the provider's expenses in
administering the contract. The number of future negative cash flows depends on the
probability of survival of the policyholder.

The provider is likely to invest his initial positive cash flow in the bond market (creating a
negative cash flow), and will receive in return a number of interest and capital payments
(positive cash flows) that he expects will match his outgoings on expenses and annuity
payments, and leave some surplus cash as profit.

1.2.2 Term assurance

A term assurance provides a lump sum on the death of the policyholder provided that this
occurs during the term of the policy. It is usually purchased by a series of annual
premiums, generally (but not necessarily) of constant amount. The annual premiums are
normally paid regularly throughout the term of the policy, but cease on death. Premiums
may be paid for a shorter period or the policy may be purchased by a single premium.

From the provider’s perspective, there will be an unknown (but limited) number of regular
known positive cash flows, followed by either a negative cash flow of known amount but
uncertain timing, or no negative cash flow (if the policyholder survives the full term). The
provider will also have negative cash flows arising from expenses, and may choose to
invest the initial positive cash flows, as in the case of the annuity.

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The policyholder's cash flows from premiums and the sum insured will be the opposite of
the provider's.

1.2.3 Endowment assurance

For an endowment assurance the cash flows are similar to those for term assurance except
that it is certain that there will be a negative cash flow for the provider at the maturity date
of the contract, if the sum assured has not already been paid on earlier death. Because of
this the regular premiums will be greater than for a term assurance. Consequently the
provider will need to invest the premiums received so that at the maturity date he can sell
the investment and have sufficient funds to meet his negative cash flow.

1.2.4 An “interest-only” loan

An “interest-only” loan is repayable by a series of interest payments followed by a return

of the initial loan amount. In the simplest of cases, the cash flows are the reverse of those
for a fixed-interest security. The provider of the loan buys a fixed-interest security from
the borrower.

In practice, however, the interest rate need not be fixed in advance. The regular cash
flows may therefore be of unknown amounts. It may also be possible for the loan to be
repaid early. The number of cash flows and the timing of the final cash flows may
therefore be uncertain.

1.2.5 A repayment loan (or mortgage)

A repayment loan is repayable by a series of amounts each of which includes partial

repayment of the loan capital in addition to the interest payment.

If the interest rate is fixed, the payments will be of fixed equal amounts, paid at regular
known times. The cash flows are similar to those for an annuity except that the number of
cash flows will usually be fixed, rather than related to survival.

As for the “interest-only” loan, complications may be added by allowing the interest rate
to vary or the loan to be repaid early. Additionally, it is possible that the regular
repayments could be specified to increase (or decrease) with time. Such changes could be
smooth or discrete.

With a repayment loan the breakdown of each payment into “interest” and “capital”
changes significantly over the period of the loan. The first repayment will consist almost
entirely of interest and will provide only a very small capital repayment. The final
repayment will consist almost entirely of capital and will have only a small interest
content. This is particularly relevant when interest and capital are taxed on different bases.

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1.2.6 Motor insurance

Typically, a motor insurance policy will provide cover for a period of one year. In return
for a premium received at the start of the year, or on a regular (monthly) basis, an
insurance company will accept the financial risks which are associated with the
policyholder’s motoring.

From the viewpoint of the company, the amount and time of receipt of the positive cash
flow (i.e. the premium) are known, but the amounts and times (and number) of any
negative cash flows are uncertain. Although damage claims are settled soon after the
incident, in some cases the negative cash flows occur some time after the conclusion of the
period of cover. This is particularly common for injury type claims for which recovery
time must be allowed and court settlements may be necessary. It is necessary for the
provider to retain funds invested to meet potential future cash outflows.

2 Characteristics and markets of the principal investment

assets
2.1 Cash on deposit
Cash can be placed on deposit with the depositor either having “instant access” to
withdraw the capital deposited, or with the depositor having to give a period of notice
before withdrawal, or for a fixed term with no access to the capital sum earlier than the
maturity of the deposit. The rate of interest paid by the borrower can similarly be fixed for
the term of the deposit, fixed for an initial period, or variable from day to day. The
borrower may have to give notice of any change in interest rates.

At one extreme, a fixed term deposit at a fixed interest rate throughout the term, all the
cash flows are certain and known in advance. At the other extreme, an instant access or
“call” account with variable interest, the amounts and timing of cash flows will be
completely unknown.

2.2 The money markets

The money markets are dominated by the clearing banks who use them to lend excess
liquid funds and to borrow when they need short term funds. These loans and deposits are
usually very short term, often overnight. Interbank rates are usually taken as the
benchmark for short term interest rates. Central banks, as lenders of last resort, stand
ready to provide liquidity to the banking system when required and also use their
operations in the money markets to establish the level of short term interest rates. Central
bank money market operations are conducted through repurchase (repo) arrangements and
the sale or purchase of Treasury and other eligible bills. Other financial institutions and
non-financial companies also lend and borrow short term funds in the money market.

Long term institutional investors such as life insurance companies and pension funds
generally hold cash only as liquidity to meet expected outgoings or, temporarily, when
taking a view that values of other assets are likely to fall.

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2.2.1 Attractions of money market investments in various economic

circumstances

Economic conditions which might make cash temporarily attractive to long term
institutional investors, or to other investors seeking to maximise returns include:

 generally rising interest rates which will depress both bond and equity markets

 the start of a recession if it is thought that equity markets will suffer from lower
growth and bonds might suffer from an increase in the government’s deficit

 weakness of the national currency making cash investments in other currencies

attractive

The stability of capital values will make cash investment attractive to risk averse investors
— this effect is enhanced in times of economic uncertainty. However, over the long term
cash would be expected to give a lower return than more risky or less liquid investments.

2.3 Bond markets

“Bond” is an alternative term for a fixed interest or index-linked security. These securities
are traded on bond markets. Bonds are described by the type of organisation issuing the
security, for example government bonds, local authority bonds, corporate bonds, etc. UK
government bonds are commonly referred to as “gilt-edged securities” or “gilts”.

The most important distinct types of bond market are:

 the markets in government bonds, listed in their country of origin

 the markets in corporate bonds, listed in their country of origin
 the markets in overseas government and corporate bonds, listed in other than the
“home” country

Overseas bonds may be denominated in the national currency, in which case there is an
additional currency risk, or may be denominated in the currency of the country in which
they are marketed.

2.3.1 A fixed-interest security or bond

A body such as an industrial company, a public body, or the government of a country may
raise money by floating a loan on the stock exchange. In many instances such a loan takes
the form of a fixed interest security, which is issued in bonds of a stated nominal amount.
The characteristic features of such a security are that the holder of a bond will receive a
lump sum of specified amount at some specified future time together with a series of
regular level interest payments until the repayment (or redemption) of the lump sum.

The investor has an initial negative cash flow, a single known positive cash flow on the
specified future date, and a series of smaller known positive cash flows on a regular set of

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specified future dates. Although the amounts and timing of these positive cash flows are
known, there is still uncertainty associated with them due to credit risk.

2.3.2 An index-linked security or bond

With a conventional fixed-interest security the interest payments are all the same amount.
Some investors are attracted by a security for which the actual cash amount of the interest
payments and the final capital repayment are linked to an “index” which reflects the
effects of inflation.

Here the initial negative cash flow is followed by a series of unknown positive cash flows
and a single larger unknown positive cash flow, all on specified dates. However, it is
known that the amounts of the future cash flows relate to the inflation index. Hence these
cash flows are known in “real” terms.

In practice the operation of an index-linked security will be such that the cash flows do not
relate to the inflation index at the time of payment, due to delays in calculating the index.
It is also possible that the borrower (or perhaps the investors) may need to know the
amounts of the payments in advance. This may lead to the use of an index from an earlier
period so that the amount to be paid is known in advance of the payment date.

2.4 The yield curve

Outlined below are theories useful in giving an intuitive feel for the factors affecting the
shape of the yield curve, interest rate risk management of bond portfolios and the pricing
of interest rate sensitive derivatives.

2.4.1 Expectations theory

Expectations theory describes the shape of the yield curve as being determined by
economic factors, which drive the market’s expectations for future short term interest
rates.

Three other theories have been formulated to explain possible deviations in the shape of
the yield curve from that expected.

2.4.2 Liquidity preference theory

The liquidity preference theory is based on the generally accepted belief that investors
prefer liquid assets to illiquid ones. Investors require a greater return to encourage them to
commit funds for a longer period. Long dated stocks are less liquid than short dated
stocks, so yields should be higher for long dated stocks.

According to liquidity preference theory, the yield curve should have a slope greater than
that predicted by the pure expectations theory or at least upwards sloping.

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2.4.3 Inflation risk premium theory

Under the inflation risk premium theory the yield curve will tend to slope upwards because
investors need a higher yield to compensate them for holding longer dated stocks which
are more vulnerable to inflation risk than shorter dated stocks.

2.4.4 Market segmentation theory

Market segmentation (or preferred habitat) theory says that yields at each term to
redemption are determined by supply and demand from investors with liabilities of that
term.

Principal buyers of short bonds are banks, which compare their yields with short term
interest rates. The major investors in long bonds are pension funds and life assurance
companies, whose main objective is protection against future inflation. The two areas of
the bond market may move somewhat independently.

2.4.5 The real yield curve

This is the curve of real yields on index-linked bonds against term to maturity. The real
yield curve, like the conventional yield curve, is determined by the forces of supply and
demand at each maturity. Thus, it can be viewed as being determined by investors’ views
on future real yields modified according to market segmentation theory and liquidity
preference theory. The government’s funding policy will also influence the shape of the
curve.

2.4.6 The relationship between real and nominal yields

The nominal yield on conventional government bonds can be expressed as

nominal yield = risk free real yield + expected future inflation + inflation risk premium.

The inflation risk premium reflects the additional yield required by investors with real
liabilities for bearing the risk of uncertain future inflation. The size of the premium is
therefore determined by the degree of uncertainty as well as the balance between the
numbers of investors requiring a fixed return and those requiring a real return.
If the inflation risk premium is ignored, the difference between nominal and real yields
gives an estimate of the market’s expectations for inflation.

2.4.7 Relationship between the yields on government bonds and other debt
securities

Government securities generally provide the most secure and marketable fixed interest
investment in a particular currency. Therefore investors will require a higher yield on
other forms of debt.

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The size of this yield margin depends on both the security and the marketability of the
debt. Relatively low security and marketability will mean a large margin whereas a large
secure issue will trade at a small yield margin to the closest equivalent government bond.

2.4.8 The relative attractiveness of fixed interest securities and index-linked

securities

In general, investors’ expectations for the relative performance of different asset classes
will depend on their views of all the factors that affect supply and demand. However,
there are particular economic circumstances when index-linked bonds will outperform
conventional bonds and vice versa.

Conventional bond yields will fall if investors’ expectations for future inflation fall or if
the size of the inflation risk premium falls. Both of these could occur with minimal effects
on the real yields on index-linked bonds and, hence, minimal change in the level of index-
linked prices. Thus, an investor whose expectation for future inflation is lower than that
implied by the difference between nominal and real yields in the market will find
conventional bonds relatively more attractive than index-linked bonds.

The converse will be true for an investor who is more pessimistic about inflation than the
market.

2.5 Ordinary shares

Ordinary shares (also known as equities in the UK and as common stock in the USA) are
securities held by the owners of an organisation. Equity shareholders own the company
that issued the shares; for example if a company issues 4,000 shares and an investor buys
1,000, the investor owns ¼ of the company. In a small company all the equity shares may
be held by a few individuals or institutions; in a large organisation there may be many
thousands of shareholders.

Equity shares do not earn a fixed rate of interest as with fixed interest securities. Instead
the shareholders are entitled to a share in the company’s profits, in proportion to the
number of shares owned.

The distribution of profits to shareholders takes the form of regular payments of dividends.
Since they are related to the company profits that are not known in advance, dividend rates
are variable. It is expected that company profits will increase over time; it is therefore
expected also that dividends per share will increase — though there are likely to be
fluctuations. This means that in order to construct a cash flow schedule for an equity it is
necessary first to make an assumption about the growth of future dividends; it also means
that the entries in the cash flow schedule are uncertain — they are estimates rather than
known quantities.

In practice the relationship between dividends and profits is not a simple one. Companies
will, from time to time, need to hold back some profits to provide funds for new projects
or expansion. Companies may also hold back profits in good years to subsidise dividends
in years with worse profits. Additionally, companies may be able to distribute profits in a
manner other than dividends, such as by buying back the shares issued to some investors.

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Since equities do not have a fixed redemption date, but can be held in perpetuity, they can
be assumed to continue indefinitely (unless the investor sells the shares or the company
buys them back), but it is important to bear in mind the risk that the company will fail. In
this case the dividend income will cease and the shareholders will only be entitled to any
assets remaining after creditors are paid. The future positive cash flows for the investor
are therefore uncertain in amount and may even be lower, in total, than the initial negative
cash flow.

2.5.1 Equity markets

Most equity investment by financial institutions and individuals is in shares that are listed
on a stock exchange. In order to obtain a listing companies have to comply with the stock
exchange’s regulations, which give investors a measure of protection. Listed shares are
also generally more marketable than unlisted ones and, hence, are easier to value because a
meaningful market value can usually be ascertained.

2.5.2 Equity categorisation

In analysing the equity market it is often helpful to categorise shares in different ways.
Shares may be classified by size of company or by expected profits growth. Another
commonly used categorisation is by industry. Equity analysts often specialise in an
industry and confine their research and advice to the relative merits of companies within
that industrial group for two main reasons, practicality and correlation of investment
performance.

2.5.2.1 Practicality

It is sensible for investment analysts to specialise within particular investment sectors

because:

 The factors affecting one company within an industry are likely to be relevant to other
companies in the same industry.

 Much of the information for companies in the same industry will come from a
common source and will be presented in a similar way.

 No one analyst can expect to be an expert in all areas, so specialisation is appropriate.

 The grouping of equities according to some common factor gives structure to the
decision-making process. It assists in portfolio classification and management.

2.5.2.2 Correlation of investment performance

Research has shown that, after overall market movements have been taken into
consideration, the share price movements of companies within industrial groupings tend to
correlate more closely with each other than with companies in other industries. The share
price movements reflect the changes that have occurred in the operating environment.
These changes affect companies in individual industries in similar ways. For this reason

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listings of share prices are often sub-divided by business sector, and major markets have
separate indices for the different sectors.

Factors affecting one company in a sector that are relevant to other companies in the same
sector include:

 Resources: companies in the same sector will use similar resources (e.g. labour, land
and raw materials), and will therefore have similar input costs.

 Markets: companies in the same sector supply to the same markets, and will therefore
be similarly affected by changes in demand.

 Structure: companies in the same sector often have similar financial structures and will
therefore be similarly affected by changes in interest rates.

2.6 Property markets

2.6.1 Characteristics of direct property investment

 Nature of return: property is a real asset and would therefore be expected to provide a
hedge against unanticipated inflation.

 Cash flow pattern: leases are for fixed terms with relatively infrequent rent reviews.
These may be “upward only”. The income stream might therefore increase in steps
every few years. However for a property that is rented at a level above current market
rents, the income stream may be fixed for many years.

The running yield (i.e. rental yield) on property varies with the type of building.

 Marketability: property is very unmarketable. It can take a long time to buy or sell
and dealing costs are high.

 Risk: the security of income depends very much on the quality of the tenant. Rent
payable by a company is a prior charge on its profits, but costs of recovery from
tenants in arrears can be high and there is a risk of “voids” — periods when the
property is not let.

Capital values of buildings can be volatile over the longer term, although infrequent
valuations and stable valuation methods reduce short term volatility. As land is
indestructible, a good site is always likely to have some value.

Owing to its political significance, property is susceptible to government intervention

such as rent and planning controls.

 Expected return: In comparison with index-linked government bonds, property is less

marketable and less secure. Investors would therefore be expected to require a higher
return from property. Property management costs are high although the tenant is often
responsible for building maintenance and insurance.

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 Unit size: the unit size of most investment in property is large and, in general, single
properties are indivisible.

 Uniqueness: each property is unique.

 Valuation: property valuation is a matter of professional judgement and there is no

central market with quoted property prices. There may be significant variations in
valuations carried out by different valuers or by the same valuer on different bases. As
sales take place infrequently the property market is characterised by a lack of
information.

 Obsolescence: land is virtually indestructible and buildings normally have a long life
if maintained in a satisfactory condition. Buildings can, however, suffer from
obsolescence. This results in a slowdown in the relative rate of growth in value
between old and new buildings. In time, expenditure on modernisation becomes
necessary.

 It is possible for the investment characteristics of individual property assets to be

substantially changed by the owner. Examples of this would be redevelopment of an
existing property or renegotiation of a lease with a sitting tenant. It is even possible to
improve the quality of a location where the investor owns a substantial proportion of
local properties.

2.6.2 Freehold and leasehold property investment

Freehold ownership is in perpetuity. A freeholder has the right to occupy the building or
let it out and, subject to planning restrictions, to refurbish the property or develop it. There
may be various restrictions on what can be done with the land. These include: covenants,
easements such as rights of way, planning and building regulations and statutory
requirements not to cause a nuisance to others.

Where possession has been given to a third party under a long lease, the buildings revert to
the freeholder at the expiry of the lease. The leaseholder pays the owner of the property an
annual ground rent. Compared with freehold investment, a leasehold interest may be of
shorter term and provides a higher initial rental yield and a capital loss if the lease is held
to the termination date. Leases of 99 or 999 years can be treated as akin to freehold
interests, save for the need to pay the ground rent to the freeholder.

2.6.3 Pooled property investments

Various vehicles exist for pooled property investment. These include open-ended unitised
funds and closed-ended investment trusts. These vehicles normally have constitutions that
specify the types of property that they can invest in, limits on liquidity, management
charges that can be deducted from the fund, etc.

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2.6.4 Property company shares

An alternative to indirect investment through a pooled property fund is investment in the

shares of a property company. In this case the largest companies can invest in properties
beyond the scope of most pooled funds. However as a commercial company, a property
company has no restriction on the investments it can make or the management expenses it
can incur. The larger property companies also invest in property developments, which
carry a greater risk than investing in an existing building with existing tenants.

Larger institutional investors in general must make a comparison between direct property
and property shares when choosing the most appropriate property investment medium.

Example

An investor is considering selling his nine properties and investing in property shares
instead.

Discuss the factors that would be considered in reaching a decision.

Solution

Advantages of direct property compared with property shares:

 Diversification of the overall portfolio: wider diversification can be achieved through

direct investment than through property shares. This is because property shares are
affected by movements of the equity market as a whole as well as by factors relating
only to property.

 Volatility: direct property values tend to be less volatile than property shares in the
short term, partly because the true picture is obscured by the effect of long periods
between valuations.

 Control: investors in property shares have little or no control over the management of
the property portfolio.

 Loss on forced sale: institutional investors are unlikely to be forced sellers of direct
property. But if a property company has a cash flow problem or is facing bankruptcy,
only forced sale values will be realised.

 A property company may invest in buildings under construction, or even land for
development. The risks associated with this type of investment are much greater than
with an established real property investment.

Disadvantages of direct property compared with property shares:

 Diversification within the property market: nine properties does not give a reasonable
spread of risk across the direct property market. Property companies can offer a
greater spread of risk for a given level of investment and, furthermore, as property

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shareholdings are divisible, it is possible to extend the spread of risk by investing in a

number of different property companies.

 Market prices/performance measurement: there is no visible market price for real

property, whereas property shares traded on the Stock Exchange have visible quoted
prices. This means that portfolio performance measurement is much more difficult in
the case of direct property.

 Marketability: property shares are much more marketable than direct property
investments.

 Management expertise: nine properties is too small a portfolio to justify internal

employment of specialist staff, so management will need to be delegated to
professional property advisors (who will charge a fee, including a profit margin). A
breadth of management expertise is provided by a property company, and management
of a property share portfolio can be carried out by the institution’s equity department.

Advantages of size: larger property companies may invest in large properties, properties
too large for all but the largest institutional funds. Larger investment/development
companies can also enter into extremely large development schemes. There may be
considerable cost savings resulting from economies of scale in the case of large property
companies.

Other factors which may influence the choice between direct property and property shares,
but which are not clear advantages or disadvantages, include the following:

 Financial gearing: commercial property investments often provide secure income

streams, which make property investment/development companies ideal vehicles for
financial gearing.

 Discount to net asset value: property shares usually stand at a discount to NAV. This
means that property assets may be purchased cheaply.

 The taxation treatment may differ, depending on the territory concerned.

The first two factors above increase the variance of the return from property shares relative
to direct investment and would therefore be expected to increase the expected return.

2.7 Futures and options

A forward contract is a contract to buy (or sell) an asset on an agreed basis in the future.
Like a forward contract, a futures contract is a contract to buy (or sell) an asset on an
agreed basis in the future. However, futures contracts are standardised contracts that can
be traded on a recognised exchange.

Having a long position in an asset means having an economic exposure to the asset. In
futures and forward dealing the long party is the one who has contracted to take delivery
of the asset in the future

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Having a short position in an asset means having a negative economic exposure to the
asset. In futures and forward dealing the short party is the one who has contracted to
deliver the asset in the future.

An option is the right to buy or sell an asset. An option writer sells options. The price
paid to the writer for an option is called the option premium

A put option is the right, but not the obligation, to sell a specified asset at a specified price
on a set date or dates in the future.

A call option is the right, but not the obligation, to buy a specified asset for a specified
price on a set date or dates in the future.

The exercise price is the price at which an underlying security can be sold to (for a put) or
purchased from (for a call) the writer or issuer of an option (or option feature on a
security). This is also known as the strike price.

Traded options are option contracts with standardised features actively traded on organised
exchanges.

A warrant is an option issued by a company over its own shares. The holder has the right
to purchase shares at a specified price at specified times in the future from the company.

An American option is an option that can be exercised on any date before its expiry.

A European option is an option that can only be exercised at expiry.

2.8 Overseas markets

2.8.1 Reasons for overseas investment

There are three main reasons why an investor may wish to hold foreign assets:

 to match liabilities in the foreign currency

 to increase the expected returns
 to reduce risk by increasing the level of diversification.

For funds with domestic liabilities the reasons for overseas investment depend on the
effect that such investments have on the expected risk/return performance of the whole
portfolio.

A major benefit of overseas investment is diversification. Investing in a number of

different countries or economies with a low degree of correlation helps to reduce risk.
Diversification is also achieved by investing in industries that are not available for
investment in the home market and gives a larger number of companies from which to
construct a diversified portfolio.

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Returns on overseas investment can be higher than domestic returns either because they
are fair compensation for the higher risk involved, or if inefficiencies in the global market
allow fund managers to find individual countries whose markets are undervalued.

2.8.2 Problems of overseas investment

Investing overseas means that investors with domestic liabilities are accepting a mis-
match, at least in the short term. Furthermore, currency movements lead to extra volatility
of the total returns. These problems can sometimes be wholly or partially overcome by
hedging the exchange risk.

A further problem of overseas investment is the cost of the increased expertise required. It
is also necessary to appoint an overseas custodian to deal with settlement, voting rights
issues, receipt of dividends and holding stock certificates etc. Costs will be further
increased by the need to recruit additional staff and set up new administrative procedures
to deal with a number of issues such as accounting for foreign currencies and repatriation
of funds.

Taxation varies from country to country. It may not be possible to recover withholding
taxes imposed on overseas investments.

Further problems that may be encountered with overseas investment include:

 Different accounting practices.

 Less information may be available than in the home market.

 Language problems — although many of the larger overseas companies publish

accounts in English.

 Time delays — timing differences have presented difficulties in the past, but advances
in communications have made this much less of a problem.

 Poorer market regulation in some countries (although some large companies are listed
in more than one major financial centre).

 Risk of adverse political developments.

 Liquidity — many less developed markets are not very liquid.

 Restrictions on the ownership of certain shares.

2.8.3 Characteristics of overseas investments

The fundamental characteristics of an overseas investment are essentially the same as

those of the equivalent domestic asset. For a particular investment there may be specific
differences that need to be considered, e.g. risk of default, taxation, and volatility of
market values.

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On top of the characteristics of an investment in its local currency, it is necessary to allow

for movements in exchange rates causing changes to the returns in domestic currency
terms.

2.8.3.1 Indirect overseas investment

Indirect means by which an investor can obtain overseas exposure include:

 Investment in multinational companies based in the home market. The advantages are
that it is easy to deal in the familiar home market while the companies will have
expertise and tend to conduct their business in the most profitable areas overseas,
including areas where direct investment may be difficult. The disadvantages are that
such a company’s earnings will be diluted by domestic earnings and that the investor
will have no choice in where the company transacts its business.

 Investment in companies with a substantial export trade. The investment is still

basically in a domestic company and its share price is likely to move in sympathy with
domestic shares.

 Investment in collective investment vehicles specialising in overseas investment.

 Investment in derivatives based on overseas assets.

In general, indirect investment is particularly suitable for small funds, although even large
funds can sometimes benefit from vehicles investing in specialist areas which are outside
the funds’ own areas of expertise.

2.8.3.2 Emerging markets

Stock markets in developing countries such as China, Mexico, Singapore, etc are known as
emerging markets. They offer high expected returns due to rapid industrialisation. They
are also very risky markets.

Emerging markets will differ from each other in practice but points to consider will
generally include the following:

 current market valuation

 possibility of high economic growth rate
 currency stability and strength
 level of marketability
 degree of political stability
 market regulation
 restrictions on foreign investment
 range of companies available
 communication problems
 availability and quality of information

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With the prospects of high growth rates, and possible market inefficiencies, opportunities
exist for profitable investment, but with a correspondingly higher level of risk. The
economies and markets of many smaller countries are less interdependent than those of the
major economic powers. Therefore investment in emerging markets may provide a good
method of diversification.

Markets in small economies can also be affected by the enormous flows of money
generated by changes in sentiment of international investors. For example, domestic
factors in the US that cause investors to repatriate funds can completely swamp economic
fundamentals in determining the level of local markets.

2.9 Collective investment schemes

Collective investment schemes (usually called mutual funds in the United States) provide
structures for the management of investments on a grouped basis. They provide the
opportunity for investors to achieve a wide spread of investments and therefore to lower
portfolio risk. Managers of such schemes are likely to have management expertise,
particularly in specialist areas such as overseas investment, which is otherwise available
only to the largest institutional investors.

There are two fundamental types of collective investment scheme; closed-ended and open-
ended. In a closed-ended scheme, such as an investment trust, once the initial tranche of
money has been invested the fund is closed to new money. After launch, the only way of
investing in an investment trust is to buy units from a willing seller (exactly as investing in
ordinary shares in a trading company). In contrast, in an open-ended scheme such as a
unit trust, managers can create or cancel units in the fund as new money is invested or
disinvested.

The regulations covering collective investment schemes vary from country to country and
different types of scheme will be subject to different rules. Regulations typically cover
aspects such as the categories of assets that can be held; whether unquoted assets can be
held; the maximum level of gearing and any tax relief available. Some schemes may only
be available to certain classes of institutional investors, such as pension funds.

2.9.1 Investment trusts

Investment trusts are a form of closed-ended fund. They are public companies whose
function is to manage shares and other investments. They have a capital structure exactly
like other public companies, and can raise both loan and equity capital. Most investment
trust shares are quoted on a stock exchange, and their shares are bought and sold in a
similar way to other quoted shares.

Investment trusts have boards of directors who are responsible for the direction of the
company, but day-to-day investment decisions are usually undertaken by investment
managers such as merchant banks or specialised investment trust managers. A number of
investment trusts may be managed by the same group of managers but have different
directors and objectives.

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Investment trusts have a stated investment objective, and new investment trusts usually
have this written into their prospectus or offer for sale documents.

2.9.2 Unit trusts

Unit trusts are an example of open-ended funds. They are trusts in the legal sense, and are
thus not subject to company law. Investors buy units in the trust, which will have a stated
investment objective.

Units can be created or cancelled with investors buying or selling their units from or to the
managers. If there is demand for units, the managers can create more units for sale to
investors. If there are redemptions (sales by investors), the managers will buy in units
offered to them.

Unit trusts have limited powers to borrow against their portfolio. They can generally only
invest the funds entrusted to them by their unit holders.

A unit trust has trustees — often an insurance company or a large bank. The role of the
trustees, as in any legal trust, is to ensure that the managers obey the Trust Deed and to
hold the assets in trust for the unit holders. The trustees oversee the calculation of the bid
and offer prices and see that the unit trust is run in a legal manner with the administration
being properly conducted. The fees to the trustees are paid by the unit trust managers.

2.9.3 Difference between closed-ended and open-ended funds

 The marketability of the shares of closed-ended funds is often less than the
marketability of their underlying assets. The marketability of units in an open-ended
fund is guaranteed by the managers.

 Gearing of closed-ended funds can make the shares more volatile than the underlying
equity. Most open-ended funds cannot be geared and those that can may only be
geared to a limited extent.

 The increased volatility of closed-ended funds means that they should provide a higher
expected return.

 Shares in closed-ended funds are also more volatile than the underlying equity because
the size of the discount can change. The volatility of units in an open-ended fund
should be similar to that of the underlying assets.

 At any point in time there may be uncertainty as to the true level of net asset value per
share of a closed-ended funds, especially if the investments are unquoted.

 Closed-ended funds may be able to invest in a wider range of assets than unit trusts.

 It may be possible to buy assets at less than net asset value in a closed-ended fund.

 They may be subject to tax at different rates.

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2.10 Collective versus direct investment

Advantages

The advantages of collective investment vehicles are greater for small investors than for
large ones. The main ones are:

 They are useful for obtaining specialist expertise.

 They are an easy way of obtaining diversification.

 Some of the costs of direct investment management are avoided.

 Holdings are divisible — part of a holding in any particular trust can be sold.

 There may be tax advantages.

 There may be marketability advantages (but they may also be less marketable than the
underlying assets).

 They can be used to track the return on a specific index.

Disadvantages

 Loss of control — the investor has no control over the individual investments chosen
by the managers.

 Management charges are incurred.

 There may be tax disadvantages such as withholding tax which cannot be reclaimed.

3 The principal economic influences on investment markets

The general level of all markets is determined by the interaction of buyers and sellers. As
demand for an asset type rises, then the general level of the market in that asset type will
rise. If demand falls, then prices will fall. Demand for most investments is very price
elastic because of the existence of close substitutes. The main factor affecting demand is
investors’ expectations for the level and riskiness of returns on an asset type. This section
considers the economic factors that affect return and risk in various markets and some
factors affecting supply in various markets.

3.1 Short term interest rates

Over the long term, interest rates are linked both to inflation and to the way demand for
money varies with the business cycle, but in the short term government actions are
generally the dominant factor. Short term interest rates are largely controlled by the
government through the central bank’s intervention in the money market. The government

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sets interest rates, directly or indirectly, in an attempt to meet its (often conflicting) policy
objectives. The main reasons for altering interest rates are given below.

3.1.1 Economic growth

Low real interest rates encourage investment spending by firms and increase the level of
consumer spending. So cutting interest rates increases the rate of growth in the short term.

3.1.2 Inflation

Lower real interest rates mean an increased quantity of money is demanded which is met
by an increase in the money supply. This can lead to inflation. Low real interest rates can
also lead to inflationary pressures by increasing demand.

3.1.3 The exchange rate

If interest rates in one country are low relative to other countries, international investors
will be less inclined to deposit money in that country. This decreases demand for the
domestic currency and tends to decrease the exchange rate.

3.2 Bond yields

Economic factors influencing bond yields include:

3.2.1 Inflation

Inflation erodes the real value of income and capital payments on fixed coupon bonds.
Expectations of a higher rate of inflation are likely to lead to higher bond yields and vice
versa.

3.2.2 Short term interest rates

The yields on short term bonds are closely related to returns on money market instruments
so a reduction in short term interest rates will almost certainly boost prices of short bonds.
However, investors in long bonds may interpret a cut in interest rates as a sign of monetary
easing, with potentially inflationary consequences over the longer term. So the yield on
long bonds might decline by a smaller amount, or even rise.

3.2.3 Fiscal deficit

If the government’s fiscal deficit is funded by borrowing the greater supply of bonds is
likely to put upward pressure on bond yields, especially at the durations in which the
government is concentrating most of its funding. Selling Treasury bills would increase
short term interest rates, while printing money will lower rates but increase expectations of
inflation.

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3.2.4 The exchange rate

A significant part of the demand for government bonds in many markets comes from
overseas. Changes in expectations of future movements in the exchange rate will affect the
demand from overseas investors. It will also alter the relative attractiveness of domestic
and overseas bonds for local investors.

3.2.5 Institutional cash flow

The demand for bonds can be affected by institutional cash flow. If institutions have an
inflow of funds because of increased levels of savings they are likely to increase their
demand for bonds. Changes in investment philosophy can also affect institutional demand
for bonds.

3.2.6 Other economic factors

Almost any piece of economic news has implications for inflation and short term interest
rates. The impact of other economic factors can therefore usually be understood in terms
of these two quantities.

3.3 The relative level of government and corporate bond yields

Economic factors, which adversely affect prospects for corporate profitability, are likely to
increase the perceived risk of corporate bonds relative to government bonds. This will
increase the general level of the yield margin of corporate over government debt.

The availability and price of government debt might affect the actions of otherwise risk-
averse investors. For example if government debt was offering very poor returns
compared with high quality corporate debt, some investors may weaken their normal risk
profile to secure the extra return. This would tend to narrow the gap between corporate
and government debt.

Supply side issues also have an impact. If equity market conditions are depressed,
companies may find it easier to raise funds through issues of corporate debt than through
equity issues. Oversupply of corporate debt reduces prices and increases yields.

3.4 Equity market values

It is investors’ expectations of future corporate profitability and the value of those profits,
which largely determines the general level of the equity market.

Amongst the main factors that influence the general level of the equity market are:

 expectations of real interest rates and inflation

 investors’ perceptions of the riskiness of equity investment
 the real level of economic growth in the economy

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In addition to the factors listed above, any factor affecting supply (e.g. the number of
rights issues, share buy-backs, or privatisations) and any factor affecting demand (e.g.
changes to tax rules, institutional flow of funds, and the attractiveness of alternative
investments) will affect market prices.

3.4.1 Interest rates and inflation

Equity markets should be reasonably indifferent towards high nominal interest rates and
high inflation. If the rate of inflation is high, the rate of dividend growth would be
expected to increase in line with the return demanded by investors.

It might be argued that high interest rates and high inflation are unfavourable for strong
economic growth, so fears of inflation will have a depressing effect on equity prices.

Real interest rates are probably more important than nominal interest rates. Investors
expecting high inflation may also expect the government to increase real interest rates in
response.

Low real interest rates should help to stimulate economic activity, increase the level of
corporate profitability, and hence raise the general level of the equity market. Also, the
rate of return required by investors should be lower, so the present value of the future
dividends will be higher.

Uncertainty about future inflation would make investors more nervous about fixed interest
bonds. Nervousness in the bond market might result in an increase in equity investment,
as equities should provide a hedge against inflation. This would tend to increase the
relative level of the equity market at the expense of the bond market.

3.4.2 Equity risk premium

The equity risk premium is the additional return that investors require from equity
investment to compensate for the risks relative to risk free rates of return.

The equity risk premium fluctuates from time to time, depending on the overall level of
confidence of investors and their views on risk.

3.4.3 Real economic growth

In general, real dividends, and therefore the fundamental value of companies, would be
expected to grow roughly in line with real economic growth. Therefore changes in
investors’ views on economic growth have a major effect on the level of the equity market.

3.4.4 Currency

A weaker domestic currency makes exports more competitive, so profits should be

increased and profits earned in other currencies are more valuable when converted into the
domestic currency.

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A weaker currency makes imports more expensive. This is bad for corporate profits to the
extent that firms cannot pass the higher costs of imported raw materials through to
consumers. Higher costs of raw materials also lead to inflation. However, if
manufactured imports are more expensive, the market share of domestic firms should
increase.

On balance, these factors work in favour of equities in countries like the UK, where a high
proportion of profits are earned abroad so sterling depreciation should raise the general
level of the equity market. However, if investors thought that interest rates would be
raised to protect the currency, this might have a dampening impact on the market.

3.5 The property market

Economic influences have an impact on the property market in three main inter-related
areas: occupation market, development cycles and investment market. The interaction
between occupational demand and the supply of property for rent determines the market
level of rents. The capital value of rented property is determined by the investment
market.

3.5.1 Occupation

Tenant demand is closely linked to the buoyancy of trading conditions and GDP. Other
things being equal, economic growth increases demand for commercial and industrial
premises. However, the impact of economic growth will not necessarily be uniform across
the different property sectors or throughout all regions of a country.

Any factor that has an effect on economic activity, such as real interest rates, will affect
occupational demand for property. For example, levels of employment in the service
sector tend to influence occupier demand for offices significantly.

New patterns of economic activity, domestically and globally, change demand patterns.
An example would be a trend for firms to move staff out of expensive capital city
locations to cheaper areas.

3.5.2 Supply of property

Property is fixed in location and takes time to develop. Markets can be viewed in terms of
the existing stock plus forecast additions to stock. But there are supply side lags and these
can be difficult to forecast. The development pipeline can be up to 5 years long.

Property use may be subject to statutory control. Local planning authorities may
frequently restrict development.

The peak of the property development cycle does not coincide with the peak of the
business cycle. The time lag between gaining consent for a property development, and
completing the construction of it, frequently results in a substantial amount of the supply
of stock coming onto the market as the economy slows down. A slow down in the
economy, coupled with rising real interest rates, is harmful to the property development
industry.

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The supply/demand relationship for the property occupation market is aggravated by the
economic characteristics of property, which lead in certain instances to disequilibrium.
These characteristics are: fixity of location, high transaction costs and segmented markets.

3.5.3 The property investment market

The state of the property investment market relies to a significant extent on the occupancy
market as this provides the investment income and the potential for rental growth.
Property investment returns have been a good hedge in the long run against unexpected
inflation. Assuming that there are no other external influences, freeholders should be able
to increase rents with inflation so that the real value of the rent is not compromised.
However, for properties with infrequent rent reviews, inflation erodes the real value of the
rental stream between reviews.

Higher real interest rates should lead to a lower valuation of future rents and therefore
lower capital values. The relationship between interest rates and property rental yields is
unclear in the short term. In the longer term, high long term bond yields tend to push up
property investment yields, other things being equal.

The sources of investment money, and whether cash flows are positive or negative, are
important in determining the state of the property investment market. The main sources
are: institutional investors, public/private property companies using bank debt, and
international investors.

Where overseas investors are significant purchasers of property the exchange rate will
have an effect on demand levels.

4 Market price levels and total returns

4.1 Factors affecting demand for different asset classes
Demand for an asset will change in one of two main circumstances:

 Investors’ opinions of the characteristics of the asset remain unchanged but external
factors alter the demand for that asset. These external factors include investors’
incomes, investors’ preferences and the price of other investment assets.

 Investors’ perceptions of the characteristics of the asset, principally risk and expected
return, alter.

4.1.1 Investors’ incomes

The amount of money available for investment by institutional investors can have a
significant impact on market prices. This is especially true of changes in the flow of funds
into institutions with tightly specified investment objectives. For example, if US open-
ended mutual funds investing in emerging markets receive a large inflow of cash they
must invest it in the markets specified in their marketing literature. This can force up

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prices in the target markets. The good returns generated might then encourage further
investment, setting off a spiral of growth.

4.1.2 Investor preferences

Investors’ preferences for a particular asset class can be altered by:

 a change in their liabilities

 a change in the regulatory or tax regimes
 uncertainty in the political climate
 “fashion” or sentiment altering
 sometimes for no discernible reason
 marketing
 investor education undertaken by the suppliers of a particular asset class

4.1.3 The price of alternative investments

All investment assets are, to a greater or lesser extent, substitute goods. This is
particularly so if we consider investment at the individual security level, but is also true
across asset classes or across international markets. There is a strong correlation between
the prices of different asset classes.

4.2 Supply factors

An increase in supply — e.g. a lot of new issues — will cause downward pressure on
share prices. In government bond markets the supply is largely controlled by the
government’s fiscal deficit and its strategy for financing the deficit.
Occasionally, supply is increased by technological innovation. It can be argued that this is
the case in the derivatives markets where a greater understanding of the pricing of and
reserving for complex products has allowed investment banks to supply them to end users
more cheaply, thus increasing the quantity demanded.

5 Total returns from different asset classes

5.1 Expected and required returns
The return that investors, as a whole, require on any asset class can be written as:

Required return = required risk free real rate of return + expected inflation + risk
premium.

The terms on the right hand side of the above equation represent market averages as
investors are considered as a class here. It is assumed that the market defines “risk free” in
real rather than nominal terms. The risk premium on a particular asset class will depend
on the characteristics of the asset and investors’ preferences, which will be largely driven
by their liabilities. A higher return would be required from riskier asset classes. The risk

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premium in the equation above may cover any adverse feature of one investment relative
to another for which investors require compensation.

Expected return can be analysed as:

Expected return = initial income yield + expected capital growth.

If assets are fairly priced, required and expected returns will be equal. One market model
that expresses this idea is the Capital Asset Pricing Model (CAPM) where expected
returns are expressed as the return on a risk free asset plus a risk premium dependent on
the systematic risk of the asset.

5.2 Analysing historical returns

In practice, investors in risky assets will not have received the returns they were expecting.
Therefore, even if assets were fairly valued at the time of purchase, risk premiums cannot
be measured simply by comparing the returns on risky and risk free assets.
The total return on an asset class can be expressed, to a first approximation, as:

Expected return = initial income yield + income growth + impact of change in yield.

Here, income growth and change in yield represent capital growth. When analysing the
expected return on asset classes over long periods of time it is also necessary to take
account of the effect of the reinvestment of income at different initial yields and second
order terms arising from the fact that the expected return is expressed as a sum of
percentage increases rather than as a product.

5.2.1 Equities

Over the long term equity dividend growth might be expected to be close to growth in
GDP, assuming that the share of GDP taken by “capital” remains constant. There is,
however, a dilution effect due to the need for companies to raise new equity capital from
time to time if dividend yields are high. The dilution effect also depends on the extent to
which economic growth is generated by start-up companies.

Equities would therefore be expected to give a real return close to the growth in real GDP
plus the equity yield. From historical data this seems to be a reasonable model, but the
short term fluctuations are significant and the actual returns achieved by investors will
depend on the exact timing of deals as well as their tax position.

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5.2.2 Conventional bonds

For fixed interest stocks there is no income growth. The initial yield and the capital value
change for a bond held to redemption combine to give a fixed nominal total return,
referred to as the gross redemption yield. The analysis of total returns compared with
inflation is relatively straightforward:

 in periods when inflation turns out to be higher than had been expected, real returns
from fixed interest stocks are lower than expected and are poor compared with
equities, and

 in periods when yields are rising, real returns from fixed interest stocks are poor

In both cases, the argument can be reversed to give the periods when fixed interest stocks
give good returns.

5.2.3 Index-linked bonds

The real return on index-linked bonds is known at outset, if they are held to redemption.
This real yield is often taken as the benchmark required real yield for the analysis of
expected returns on equities. However, if index-linked bonds are sold before redemption
then the actual real return will depend on the price for which the bonds are sold. This will
be influenced by the normal supply and demand issues.

5.2.4 Cash

Returns on cash might be expected to exceed inflation except in periods where inflation is
rising rapidly and is under-estimated by investors. Short term real interest rates can also
be kept very high or very low by governments for significant periods.

5.2.5 Earnings

A reasonable assumption over the long term would be that wages and salaries would grow
in line with GDP.

END

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UNIT 7 — CAPITAL REQUIREMENTS

Syllabus objectives

3.5.1 Discuss why the main providers of benefits on contingent events need capital.

3.5.2 Describe how the main providers of benefits on contingent events can meet,
manage and match their capital requirements.

3.5.3 Discuss the implications of the regulatory environment in which the business is
written for provisioning and capital requirements.

3.5.4 Discuss different measures of capital needs.

3.5.5 Discuss the relative merits of looking at an economic balance sheet in order to
consider the capital requirements of a provider of benefits on contingent events.

3.5.6 Discuss the use of internal models for assessment of economic and regulatory
capital requirements.

1 Capital needs
Capital management involves ensuring that a provider has sufficient solvency and
cashflow to enable both its existing liabilities and future growth aspirations to be met in all
reasonably foreseeable circumstances. It also often involves maximising the reported
profits of the provider.

All individuals and corporations need working capital. For individuals this enables them
to survive the financial consequences of an unexpected event, such as their car needing
repair. Individuals might also wish to build up capital, to save for a large future expense,
such as a holiday or a child’s marriage.

Corporations need capital for very similar purposes — a cushion against fluctuating trade
volumes, or to build up funds within the company prior to a planned expansion. Trading
companies need capital to finance stock and work in progress, because they have to pay
suppliers of goods and services before they are paid for the finished product. In addition
all companies need “start-up” capital — to obtain premises, hire staff, purchase
equipment, etc., before they can start in business.

A provider of financial services products has all the same needs for capital as other
companies. However the long-term nature of financial services products, and the
associated uncertainties, gives rise to additional capital requirements over those considered
in the preceding paragraphs.

When a provider agrees to pay benefits on future financial events there is a possibility that
the event leading to payment will arise before the provider has had time to accumulate
sufficient funds from premiums/contributions to pay the benefits. There is thus a need for

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Subject CA1 Capital requirements 2016

“start-up” capital that is not repaid when the initial contracts terminate, but is rolled
forward.

Because of the uncertainties generated by the long-term nature of financial products, there
may also be a statutory or regulatory requirement to hold a provision for the future
liabilities in excess of the best-estimate value of the future outgo. This will mean that
capital will be required to purchase the additional assets required. At the start of an
enterprise or during a time of expansion additional capital may be needed to meet such a
statutory requirement.

In addition when taking on liabilities for the first time or when taking on a new type of
liability there will be costs for the provider in:

 setting up suitable management systems to administer the liabilities

 collecting premiums/contributions
 paying commission to third parties
 investment expenses
 administration expenses

Until sufficient premiums/contributions have been collected the provider will need to meet
these start up costs from capital. If business volumes remain level this additional capital
can be rolled forward to the next tranche of business. If volumes increase additional
capital will be required, while if volumes reduce some of this capital can be released.

If a provider makes a decision not to hold a portfolio of assets that replicates its liabilities,
its capital requirements will increase. This is because there is a danger that movements in
experience and in particular in interest rates may result in the liabilities increasing by more
than the assets. Capital will provide a cushion to absorb any deficits arising in this way.

The level of a provider’s capital will have a key role to play in achieving its overall
strategic direction. For example, capital levels will impact acquisitions, mergers,
demutualisations and new ventures.

Capital can be used to smooth income statements and improve the solvency and matching
position of the balance sheet for a provider.

The levels of guarantees in a product impact the level of solvency margins a company has
to hold and will therefore impact on capital requirements.

The financial strength of providers may be significant in determining new business levels.
Financial strength may be rated as one of the key determinants used by individuals and
their advisers when deciding whether or not to place business with any particular provider.

The capital requirements of the State are very different from those of providers. State and
government sponsored organisations do not need to build up capital because, in a
developed economy, they can raise taxes or borrow money to gain funds to meet
government outgo. The State can print money if other methods of raising funds are
insufficient, although printing money is inflationary. Nevertheless, governments tend to
build up and try to maintain reserves (often in gold or foreign currencies) to support

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fluctuations in the balance of payments and in the economic cycle. Governments also
need short-term funds because of timing differences between government income and
outgo.

2 How providers meet, manage and match capital needs

All companies can increase their working capital by retaining profits or surpluses within
the business and not distributing them as dividends or bonuses.

A proprietary company may raise funds through the issue of shares or debt securities.
Issues can be to existing shareholders (rights issues) or to new shareholders (tender offers,
etc).

A mutual company has less access to the capital markets. Mutuals can only start by an
altruistic gesture. Essentially this involves someone lending the initial capital, but without
any requirement for the loan to be repaid unless profits emerge. There is then no liability
for repayment that needs to be taken into account in the mutual society’s balance sheet.
Mutual insurance companies can raise capital through the issue of subordinated debt,
where repayment is subordinate to the calls from all other creditors.

The sponsor of a benefit scheme may be prepared to put up the initial capital for the
arrangements, particularly those required to cover the expenses of setting up the scheme.

A provider can also limit the amount of capital it needs by passing its liabilities to another
provider through reinsurance. The need for reinsurance usually decreases as the amount of
assets held by the provider increases.

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.

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.

3 The regulatory environment

3.1 Solvency capital
A provider of financial benefits will need to hold reserves or provisions for liabilities that
have accrued but which have not yet been paid, for future periods of insurance against
which premiums have already been received, or for claims already incurred but which

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have yet to be settled. One of the regulator’s roles is to ensure that financial promises
made to members of the public are kept.

For this purpose, the regulator will monitor the adequacy of the provisions that the
provider sets aside against future liabilities. It may even prescribe the basis (assumptions
and methodology) by which these amounts are calculated. Given that the future is
impossible to predict, the assumptions will contain margins above those that might be
assumed on a best estimate basis. Further, to encompass this uncertainty, the regulator
may require that the provider hold further “free” capital i.e. not specifically to back
liabilities, as a buffer for general adverse experience.

The total of this additional capital in excess of the provisions established and the margins
between the best estimate basis and the regulatory liability valuation basis is called the
solvency capital requirement. In some countries, or for some types of financial provider,
the solvency capital requirement comprises a highly prescriptive, prudent valuation basis
with no or negligible additional amount. In other regulatory regimes the basic provisions
are established on a best estimate basis, and substantial additional capital needs to be held.
The security given by the regulatory regime is measured by the total of the two elements
of the solvency capital required.

3.2 Solvency II for insurers

One example of a capital adequacy regime for insurance companies is Solvency II which
becomes operative on 1 January 2016. Solvency II is a regulatory regime for all European
Union states. The new framework is based on three pillars:

 Quantification of risk exposures and capital requirements

 A supervisory regime
 Disclosure requirements

Solvency II will establish two levels of capital requirements:

 The Minimum Capital Requirement (MCR) — the threshold at which companies will
no longer be permitted to trade

 The Solvency Capital Requirement (SCR) — the target level of capital below which
companies may need to discuss remedies with their regulators

The SCR may be calculated using a prescribed standard model or a company’s internal
model, where the latter may be benchmarked against the output of the standard model. It
is likely that considerable work will be needed to justify using an internal model, and all
but the largest companies are likely to find that any reduction in capital requirements is
more than offset by the work needed to support the internal model. 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 is expected to use an internal model.

The Solvency II Directive will apply to all insurance and reinsurance companies with
gross premium income exceeding €5 million or gross technical provisions in excess of €25
million.

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2016 Capital requirements Subject CA1

3.3 The Basel Accords for banks and credit institutions

Solvency II provide solvency requirements for insurance companies’ risks, comparable
measures of capital adequacy for banks are the Basel Accords issued by the Committee on
Banking Regulations and Supervisory Practices of the Bank for International Settlements
(BIS).

These accords set requirements for the levels of capital that banks need to hold to reflect
the level of risk in the business that they write and manage.

4 Measures of capital needs

The approaches discussed in the previous section can be used to determine regulatory
capital needs. However a provider should not run a business solely on the basis of a
regulatory requirement, and thus the concept of Economic capital should be considered.

Economic capital is the amount of capital that a provider determines is appropriate to hold
given its assets, its liabilities, and its business objectives. Typically it will be determined
based upon the risk profile of the individual assets and liabilities in its portfolio, the
correlation of the risk and the desired level of overall credit deterioration that the provider
wishes to be able to withstand.

Depending on the provider and its regulatory regime, either economic or regulatory
requirements may drive the need for capital. To meet the need for either economic or
regulatory capital, various types of capital can be used. The cost to provider of the various
forms of capital will depend on the level of relative risk exposure to the investor and on
the availability of capital at any time in the market.

5 Economic balance sheet

5.1 The basic economic balance sheet

The first stage in a risk-based capital assessment for a provider is to produce an economic
balance sheet. An economic balance sheet shows the market values of a provider’s assets
(MVA), the market values of a provider’s liabilities (MVL) and the provider’s available
capital, which is defined as the difference between the MVA and the MVL. The available
capital is then compared with the economic capital requirement to assess the provider’s
solvency status.

Market values of assets are usually easily and instantly available from the financial
markets.

The determination of a market value for a provider’s liabilities is not so easy and a high
level of judgment is required to determine market consistent liability values. One
approach is to determine the expected value of the unpaid liabilities stated on a present
value best estimate basis and to add a risk margin. The risk margin could be determined

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Subject CA1 Capital requirements 2016

using the “cost of capital” approach. An alternative approach is to use option pricing
theory, the detail of which is outside the scope of this course.

The value of using an economic balance sheet as a starting point for capital requirement
assessment is that it starts with assets and liabilities both being assessed on the same,
market consistent, basis. Other methods that involve a deterministic valuation of liabilities
necessarily use a basis that does not set out to be market consistent. In particular most
liability valuation bases used for supervisory purposes have an inbuilt prudential margin,
to a greater or lesser extent, depending on the regulatory regime.

6 Internal models for assessing capital requirements

Under the Solvency II standard model, the capital requirement is determined through a
combination of stress tests, scenarios and factor-based capital charges. The standard model
allows for underwriting, market, credit default and operational risks. It aims to assess the
company’s net risk and determine its capital requirement after recognising all the risk
mitigation arrangements the provider has in place.

Using the standard model has the advantage that the Solvency Capital Requirement
calculation is less complex and less time-consuming. However, using the standard model
has the disadvantage that it aims to capture the risk profile of an average company, and
approximations are made in modelling risks which mean that it is not necessarily
appropriate to the actual companies that need to use it.

As an alternative to using the standard model for deriving Solvency II capital adequacy
requirements a company can use an internal model of its risks. Internal models aim to
create a stochastic model that reflects the company’s own business structure. Companies
can also use internal models:

 to calculate its economic capital using different risk measures, such as Value at Risk
(VaR) and Tail Value at Risk (TailVaR)

 to calculate levels of confidence in the level of economic capital calculated

 to apply different time horizons to the assessment of solvency and risk

 to include other risk classes not covered in the standard model

END

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2016 Contract design Subject CA1

UNIT 8 — CONTRACT DESIGN

Syllabus objectives

4.1.1 Discuss the factors to be considered in determining a suitable design for financial
structures e.g. products, schemes, contracts or other arrangements that will provide
benefits on contingent events in relation to:

 the characteristics of the parties involved

 the risk appetite or risk aversion of the parties involved
 the level and form of benefits to be provided
 any options or guarantees that may be included
 the benefits payable on discontinuance or transfer of rights
 the method of financing the benefits to be provided
 the choice of assets when benefits are funded
 the charges that will be levied
 the capital requirements

4.1.2 Describe how the design of products, schemes, contracts and other arrangements
can be used to help develop corporate human resource strategy.

1 Design of financial structures

1.1 The characteristics of the parties involved
The parties involved are:

 the client or clients

 the clients’ customers
 actuaries
 lawyers
 accountants
 financial backers
 administrators

The clients and their customers will want financial structures that meet their needs in a
cost-effective manner.

The client’s actual needs will be influenced by:

 the chosen market

 the capital available
 the expertise available

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The client’s customer’s actual needs will be influenced by:

 capacity to pay
 the risks to be covered
 the benefits that are needed at a different times in the future
 attitude to financial risk

Actuaries will be involved in the initial costing of the financial structures and the
subsequent determination of the provisions that will need to be held to meet future
liabilities. They will also be involved in the design process through assessing the impact
on both the cost and the reserving implications of modifications to the benefit design.

Lawyers will be involved in the drafting of the contracts supporting the financial structures
to ensure that the provider is not exposed to the risk of providing more benefits or entering
into greater risks than intended.

Accountants will be involved in ensuring that the provider of the financial structures
properly accounts for the income and outgo.

The financial backers will want regular reports demonstrating proper stewardship of the
finance provided.

Administrators will need to administer the financial structures. The more complex the
financial structures are the greater the cost of administration will be. This should be
reflected in the amounts paid by the client.

1.2 Risk appetite — risk aversion

It is important that the financial structure as designed meets the risk profile of the intended
purchaser, and that the risks involved in the product are clearly explained to the end
customer. The different risk appetites of different clients are covered in Unit 3.

Sales of a financial product will be optimised if the product can be designed to be suitable
for customers with a wide range of risk appetites. For savings products, whether insurance
contracts or benefit schemes, this can be achieved by offering a range of investment
choices. Having a range of funds available means that the contract can allow for any
change in the customer’s risk appetite during the term of the policy.

The risk averse investor can select investment funds that are designed for the cautious
investor. These funds might have a significant percentage in cash or short dated bonds,
with a relatively small equity content. The equity content might further be restricted to
invest only in “blue-chip” companies.

The speculative investor can choose a fund with a low or zero fixed interest content, and
where the equity content is unconstrained. Equity investments might include unquoted
companies, emerging markets, and high risk industries.

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General insurance products normally deal with clients’ risk appetite through the range of
risks that are insured. For example motor insurance is commonly written on three bases:

 third party only

 third party, fire and theft
 fully comprehensive

1.3 The level and form of benefits to be provided

The level and form of benefits to be provided under any specific financial structure may
vary according to the client’s needs, the risks to be covered and the client’s ability to pay.
For example some car owners may want full cover against damage to or theft of their car,
combined with legal protection and an additional premium to protect any no-claims bonus
they have accumulated. Other car owners may just want the minimum cover to enable
them to drive legally.

1.4 Any options or guarantees that may be included

Any options or guarantees that are included in the financial structure will need to be
charged for. Ideally this should be a charge included in the premiums paid. The
alternative is to charge for them through a reduction in the amount paid when the benefits
fall due. While not charging for options and guarantees from the outset may aid sales, the
adverse reaction of clients whose benefits are unexpectedly reduced on payment is likely
to outweigh the earlier benefit.

1.5 Benefits on discontinuance or transfer of rights

The principles underlying the determination of the benefits payable on discontinuance or
transfer of rights are broadly the same for insurance contracts and benefit schemes in that
the amount offered on discontinuance should be fair to:

 the policyholder or scheme member

 other policyholders and scheme members
 the provider of the benefits

An insurance company needs to decide the contracts for which it will offer discontinuance
terms. These may be governed by market practice, regulatory requirements or simply the
difficulty of assessing suitable terms, for example the lump sum to pay on the
discontinuance of an immediate annuity. The provider will also consider the cost involved
in determining and implementing the terms compared with the benefit available on
discontinuance. Where discontinuance terms are offered, these could take the form of a
payment of a lump sum, or a conversion of the contract to a paid-up status with no more
premiums being payable. For some types of contract the discontinuance terms, or the
method of calculating them, may be guaranteed as part of the contract.

It is natural for a policyholder to compare the lump sum discontinuance benefit after a few
years’ duration with the premiums paid or even premiums plus some interest. However,
the discontinuance benefit at such a stage will often, if not usually, be less than the sum of

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premiums, or even negative, as significant initial expenses will have been incurred. If
expenses exceed premiums then clearly the company cannot avoid making a loss.
However, it may feel obliged to accept a loss, or at the least a reduced profit, on
discontinuance up to several years into the contract so that the lump sum paid does not
appear too low compared to premiums paid.

Where a benefit will become payable on the maturity of a contract, the policyholder will
expect that a lump sum payable on discontinuance just prior to maturity will be consistent
with it.

In some countries there may be requirements on providers to present certain information to

potential policyholders. This may include illustrations of discontinuance terms based on
existing methods. This requirement may influence the extent that policies terminating
later, or even those remaining to maturity, subsidise the benefits offered on short duration
discontinuance.

For a benefit scheme the benefits on discontinuance are likely to be known, but if they are
to be transferred to another provider a value will need to be placed on them. The value
will need to be equitable between members who leave the scheme and members who stay
in the scheme. In particular as the assets available to provide the benefits may only be
those that are funded, they may be insufficient to provide the full value of the benefits for
all members. In such a situation any payment to a member leaving the scheme may be
reduced to reflect the lower level of funding. In such a situation the member may have the
option not to transfer benefits away but to retain the full discontinuance benefits in the
scheme.

Where the whole benefit scheme is being discontinued and there are insufficient assets in
the scheme to provide all the promised benefits then the accrued benefits will also be
reduced. If the benefits are to be reduced, legislation or scheme rules may indicate which
types of benefits are to be reduced or which types of beneficiaries are to have their benefits
reduced.

Where a scheme discontinues with assets more than sufficient to meet the benefit rights of
the members, the surplus may pass back to the sponsor. Alternatively, legislation or
scheme rules may require the surplus funds to be used to increase the benefits for
members. Either way, it would be usual for all members to be granted their basic rights
before any are granted additional benefits.

1.6 The method of financing the benefits to be provided

Whenever there is a period of time between a financial structure being set up and the
benefits actually being provided, there is a choice as to how and when monies should be
set aside to pay for the benefits.

The range of options that could be followed are:

 pay as you go

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2016 Contract design Subject CA1

 funding all the benefit in advance

 regular payments building up a fund

 paying an amount when the benefit event happens for example purchasing an annuity
at the point of retirement

These ideas are developed further in Unit 15.

1.7 The choice of assets when benefits are funded

If benefits are funded in advance, a decision will be required as to the manner in which the
funds are to be invested. The range of possibilities, and the considerations to be taken into
account, are covered in detail in unit 6. The final choice depends critically on attitude to
risk of all the stakeholders. This topic is dealt with in Unit 3.

1.8 The charges that will be levied

The charges that are levied will need to meet the costs incurred by the provider in setting
up and managing the financial structures in place.

For example, for an insurance company the costs will include:

 contract design
 advertising/sales
 commission
 the administration of setting up new client records
 the ongoing administration of collecting contributions/premiums etc.
 the administration of paying the benefits as they fall due
 management of assets
 the profits of the provider
 the overheads of the provider e.g. rental of office space, IT departments etc.

1.9 The capital requirements

The capital requirements depend on the “riskiness” of the benefits promised. Some
“attractive” contracts may require the provider to hold too much capital even if they can
sell the contracts on profitable terms. This might particularly be the case where the
regulatory capital requirements are assessed on a basis that is inconsistent with the
economical capital requirements of the contract.

Example

A medium sized final salary pension scheme incorporates both retirement and death in
service benefits. The trustees have asked the actuary to draft a short report discussing the
possible ways of using insurance contracts to reduce the mortality risks and uncertainties.

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Subject CA1 Contract design 2016

Set out the points that would be made in the report, which should include:

(a) The features of the different insurance contracts that may be used.
(b) The advantages and disadvantages of using insurance contracts.

Solution

(a) Deferred annuities could extinguish a scheme’s liability to a member with an

entitlement to a deferred pension. The annuity may have to increase in both
deferment and payment, either at a fixed rate or at a rate linked to an inflation
index.

Immediate annuities purchased by a single premium could remove a liability to a

current pensioner. The immediate annuities may be level, increasing at a fixed
rate or increasing in line with a given index. They may continue after death to a
surviving spouse, at either the full or a reduced amount.

Group life term assurances could extinguish lump sum death in service benefits.
They provide a lump sum on death within a specified term.

(b) The advantage of using immediate annuities and deferred annuities is that they
remove the longevity risk, the inflation risk and the investment risk.

The disadvantages of using immediate annuities and deferred annuities are:

 The upside longevity, inflation and investment risks are passed to the insurer.

 The purchase price has to cover insurance company expenses and a

contribution to its profit.

 There is an immediate liquidity constraint when buying the annuity.

 Dealing with issues such as future addition of discretionary pension increases

becomes complicated.

The advantages of using group life term assurance are:

 They remove the mortality risk to the scheme.

 They provide greater predictability in the cost of the death benefits.

 They reduce the large variability in the amount and timing of death in service
costs in an uninsured scheme. This is particularly important for small
schemes, which are vulnerable to adverse mortality experience with the
possibility of a small number of large claims rendering the scheme insolvent.

 Insurance alleviates the liquidity problems of paying large claims all in one
go.

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The disadvantages of using group life term assurance are:

 The upside mortality risk is passed to the insurer.

 The purchase price has to cover the insurance company’s expenses and a
contribution to profit as well as covering the actual cost of the benefits.

2 Corporate human resource strategy

When considering benefits that might be provided to employees, an organisation should
identify the drivers of profitability. Employees can then be made aware of their
contribution to the profitability of the organisation. Each employee can then be rewarded
according to their performance in managing the drivers of profitability that they can
control. The contract design chosen should be such that it is tailored to the needs of the
workforce or subgroups of the workforce. For example the needs of a young workforce
engaged in manual work may differ from those of the executive board of the same
employer.

Flexible benefit systems are useful when it is inappropriate to provide all employees in an
organisation with the same benefit package. Under flexible benefit systems employees are
offered the option to revise the level of an existing benefit or to choose different benefits,
which the employee “buys” either by reducing their pay or by giving up part of their
existing benefits. Flexible benefit systems recognise that employees’ needs change over
time by allowing them to adjust their package each year. The choices offered by flexible
benefit systems can help meet the different needs of employees in several ways:

 allowing them to select from a menu of different benefit options

 different groups within the workforce (e.g. single, married, with dependants, without
dependants, young, old etc.) can select benefits appropriate to them

 benefit packages can change over time as personal circumstances change

 new benefits can be offered at little or no cost to the employer.

END

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2016 Project planning and management Subject CA1

UNIT 9 — PROJECT PLANNING AND MANAGEMENT

Syllabus objectives

4.2.1 Describe the process of project management.

4.2.2 Show how actuarial techniques can be used in the assessment of capital
investment projects and cost-benefit analyses.

4.2.3 Discuss how the risks of the project are taken into account in project management.

1 Project management
There are many occasions when an actuary will be required to work on a project with other
professionals such as accountants, lawyers or systems analysts. Examples are the
development and launch of a new financial product, the merger of two insurers and the
sale of one business to another where pension liabilities are also being transferred. The
careful planning and management of a project is vital if it is to be a success.

Central to the management of projects is the need to develop the project definition in a
timely and cost effective manner, with minimal changes occurring later in the project. This
will enable the real needs of the project customer to be met.

Projects need:

 a clear definition of the aim of the project which reflects the needs of the customer

 full planning

 thorough risk analysis

 monitoring of development

 measurement of performance and quality standards

 thorough testing at all stages

 care in managing different strands of the project to ensure that there are no
unnecessary delays in one part of the project which depends on the outcome of another
(critical path analysis)

 to move along at the appropriate pace so that the right things are done at the right time

 stable but challenging relationships with suppliers of external components of the

project

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Subject CA1 Project planning and management 2016

 a supportive environment

 excellent communications between those involved

 positive conflict management, which uses conflict as a source of ideas and a tool for
development

 a schedule of what needs to be considered at each milestone review point

Projects need to be led by strong experienced people who can drive them forward. Such
individuals should be able to establish direction, decide on action, organise resources and
motivate the project team. However, there should be checks and balances on the
enthusiasm of the project’s champions.

There should be a clearly worked out written strategy for the project setting out:

 the aims of the project

 the issues necessary for the implementation of the project
 the areas of risk that could affect the viability of the project
 alternative strategies for dealing with areas of risk

A key element of any sizable project is to have a comprehensive master schedule for the
project that ensures that the right people do the right things at the right time. The right
people include both those internal to the project and external suppliers.

The written strategy should usually include the following:

 a clear identification of the objectives of the project

 statements on how these objectives will be met
 the acceptable quality standards for meeting the objectives
 the project sponsor’s role
 the role of any third parties e.g. consultants employed
 the financial and economic objectives
 details of the expected cost of the project
 the financing policy
 the policy for dealing with legal issues
 the need for insurance or reinsurance
 the technical policy
 a structured breakdown of the work to be completed under the project
 the key milestones for reviewing the project
 the risk management policy
 the communications policy
 the information technology policy
 policy for dealing with conflicts of interest

It is vital that setting the standards of performance required from the parties involved is
undertaken early in the life of the project, as these will have a major impact on the whole
project.

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Once the strategy and objectives have been written and the objectives of the project have
been set a development schedule is needed setting out how and when the project will be
undertaken.

The written strategy should be shared with the key individuals who will bear the
responsibility for implementation of the project. It will be necessary to review the
development schedule at regular intervals and particularly when the key milestones in the
schedule are reached.

A thorough risk analysis should be carried out.

Technical and design changes should be avoided once implementation has begun. Design
parameters should be broad enough to give the developers some freedom of approach and
to avoid the need for subsequent changes. Strict change control management should be
implemented.

Any new technology should be fully tested before being released for use.

A competent team should be in place from the outset. Where appropriate the end users of
the project’s output should be involved from the start. The team should have a strong
leadership and management to ensure that the right things are done at the right time to
make the project a success. It is important that all the team members are committed to the
success of the project and that the project leaders provide support.

Major project interfaces need to be managed, examples include those between:

 designers and builders

 specifiers and implementers
 project owners and project managers

The distinction between the project owner as the sponsor and future operator of the project
outcome and the project management team as the designers and builders of the project is a
particularly important one. The project owner will, of necessity, be involved in some of
the project management issues. However, ensuring a successful project outcome requires
the right balance to be struck between the owner as the project sponsor and operator and
the project implementation specialists.

Project owners should concentrate on the agreed milestone review points — the key
indicators in the project’s development schedule that should have been reached at certain
stages — to ensure that they are properly scheduled and that the project is fully reviewed
each time it reaches a milestone review point. At these milestone review points, critical
questions on all aspects of the project should be raised by all those involved in the project.
In some cases, to get an unbiased view of progress, it may be appropriate for an
independent party to carry out the milestone reviews.

The tools for planning, monitoring and reporting on the progress of a project should:

 be user friendly
 allow technical, financial and other issues to be tracked

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 enable final outcomes to be predicted reliably

The actuarial control cycle forms a good basis for the management of many projects.
The extent and level of complication in any project planning exercise will depend in part
on the size of the project. However, the principles of project management can be applied
to most work related tasks regardless of their size.

2 Use of actuarial techniques in the assessment of capital

investment projects
2.1 Methods used to determine viability of a capital project
Here a capital project means any project where there is initial expenditure and then, once
the project comes into operation, a stream of revenues less running costs. A capital project
does not have to involve the construction of a physical asset.

The main purpose of the initial appraisal of a proposed capital project is to ascertain
whether the project is likely to satisfy the criteria that have been established by the
sponsoring organisation for projects it is prepared to authorise. These criteria will
typically be expressed in terms of the financial results expected and (sometimes) the risk
that these results may not be achieved. However, there may be many additional criteria in
practice, including:

 achieving synergy or compatibility with other projects undertaken by the sponsor

 satisfying “political constraints”, both within and without the sponsoring organisation
 having sufficient upside potential
 using scarce investment funds or management resources in the best way

These criteria often cannot be factored into a financial model, and a subjective assessment
will have to be made of their impact once the financial results are available.

During the appraisal process it will be necessary to investigate the risks involved in the
project and come to a view on the best course of risk mitigation, having regard to the costs
involved. The remaining risks will need to be listed for the benefit of sponsors, lenders
and investors, so that they can take these risks into account in the decision-making
process.

The first step is to define the project and its scope carefully and to assess its likely length
of operating life. There should then be an evaluation of the most likely cash flows for
capital expenditure, running costs, revenues and termination costs. The cash flows should
allow for any consequential effects on the sponsor’s other activities or costs. Accurate
definition and evaluation of the most likely cash flows is crucial to the success of the
subsequent work, as these constitute a baseline. All the assumptions should be carefully
documented.

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Using these cash flows, the next step is to make an initial evaluation of the likely financial
result of undertaking the project. A discounted cash flow approach is normally used.
Calculations often made are of the:

 net present value (NPV)

 internal rate of return (IRR)

 payback period, i.e. the length of time before the capital expended on the project is
recouped from the net revenues (consisting of the gross revenues less running costs),
without discounting the cash flows

 discounted payback period

The IRR equation can sometimes have multiple solutions, especially if there are net
negative cash flows at some points during the operating life of the project or at
termination. In addition if a project does not require a large amount of initial capital, a
very high IRR could be generated, but the project still make an inadequate absolute profit.
These features have helped make the IRR less popular than the NPV as a measure of
project worth.

Normally the result of a NPV calculation will be regarded as satisfactory if it is positive

and the result of an IRR calculation will be regarded as satisfactory if it exceeds a
predetermined “hurdle rate” set by the sponsor. The payback period will be regarded as
satisfactory if it is less than a predetermined period set by the sponsor.

The results of these calculations will provide an initial appraisal of the financial viability
of the project. A broad idea of the sensitivity of the results to varying assumptions can be
obtained by assuming that all the costs are (say) 10% higher than the most likely values
and all the revenues are (say) 10% worse than the most likely values. The results obtained
might, if very unsatisfactory, suggest that further analysis is not worthwhile without some
fundamental redesign of the project. If the results appear satisfactory, a detailed risk
analysis should take place.

2.2 Choice of risk discount rate

The main considerations to take into account in determining the discount rate to use in
NPV calculations are summarised below. Similar considerations apply to the
determination of hurdle rates of return.

The normal practice in financial services projects is to factor inflation into the cash flows,
and use a nominal risk discount rate.

Projects with inherently high risks, which cannot be sufficiently taken into account by
specific risk analysis, should usually be appraised on the basis of a higher discount rate
than projects having normal degrees of risk. Thus an international company might apply a
higher discount rate to projects located in countries with unstable political regimes.

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The following looks at the method of choosing a discount rate for projects deemed to carry
a “normal” degree of risk and then considers how the discount rate should be increased if
there is a higher than usual degree of risk. It assumes that the sponsor is a commercial
company. Special considerations, which will not be considered here, apply in choosing
discount rates for use by the public sector.

The starting point is the current cost of raising incremental capital for the company in
order to carry out the project. One way of looking at this cost considers it to be the rate of
return that needs to be earned on the capital if the existing shareholders are to be no better
off and no worse off.

This should be the company’s normal cost of raising capital, taking this as a weighted
average where the weights are based on the optimum capital structure for the company as
between equity and debt. (If the company’s capital structure is not currently optimum, it
could be made optimum through a separate decision).

The cost of debt capital should be taken as the cost in real terms of new borrowing by the
Company. This is calculated by taking an appropriate margin over the current expected
total real return on index-linked bonds, having regard to the company’s credit rating, and
multiplying by (1  t), where t is the assumed rate of corporation tax. The cost of equity
capital is the current expected total real return on index-linked bonds plus a suitable
margin to allow for the additional return that equity investors seek to compensate them for
the risks they run.

This gives a real discount rate, to be applied to cash flows expressed in present-day
monetary values, or adjusted by the assumed future inflation rate and used with cash flows
in nominal terms.

If the company is considering a project with a degree of systematic risk higher than is
usual for its projects, the discount rate used should be greater than that which the company
normally employs.

“Systematic risk” is that part of the variability of return on a project which cannot be
eliminated by investing in the same type of project many times over, or by diversification,
because investing in a number of projects cannot reduce this part of the variability to zero.
Systematic risk can vary from one project type to another.

One guide might be to consider the discount rates appropriate for use by companies that
habitually engage in such projects. In practice such data may be hard to obtain and there
may be no alternative but to make an arbitrary addition to the discount rate.

In a life assurance company, projects are frequently financed from within the long-term
insurance fund. This is often the case for with profits companies, or companies with
significant free reserves, and always the case for mutuals. Here the decision is whether the
project is a better investment for the owners of the capital than other forms of investment,
after allowing for any risk differential. The starting point for the risk discount rate (in
nominal terms) might therefore be the expected long term return on equity-type
investments.

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It is not uncommon for companies to use very high discount or hurdle rates when
appraising proposed projects. However, the use of a discount rate that is too high distorts
the relative weights placed on the short term and on the longer term, thereby leading to
mistaken decisions as it does not generate a uniform contingency margin.

On the other hand, too much precision in setting the risk discount rate is unnecessary since
the results of NPV calculations are not usually very sensitive to small chances of, say, 1%
p.a. in the discount rate. It would usually be appropriate to carry out the NPV calculations
on two alternative discount rates (say 6% and 10% p.a. real), and if both results are
satisfactory, then there is no need to worry too much about determining the most
appropriate discount rate precisely.

3 Project risks
3.1 Identification of risks
The steps necessary to achieve an effective identification of the risks facing the project can
be summarised as follows:

Make a high-level preliminary risk analysis to confirm that the project does not obviously
have such a high risk profile that it is not worth analysing further.

Hold a brainstorming session of project experts and senior internal and external people
who are used to thinking strategically about the long term. The aim will be to:

 identify project risks, both likely and unlikely, and upside and downside

 discuss these risks and their interdependency

 attempt to place a broad initial evaluation on each risk, both for frequency of
occurrence and probable consequences if it does occur

 generate initial mitigation options and

 discuss them briefly

Carry out a desktop analysis to supplement the results from the brainstorming session, by
identifying further risks and mitigation options researching similar projects undertaken by
the sponsor or others in the past (including overseas experiences), and obtaining the
considered opinions of experts who are familiar with the details of the project and the
outline plans for financing it.

Carefully set out all the identified risks in a risk register, with cross references to other
risks where there is interdependency.

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3.2 Risk mitigation

For each major risk, consideration would be given to identifying the main options for
mitigating the risk by such methods as:

 avoiding the risk (e.g. by redesigning the project)

 reducing the risk, i.e. either reducing the probability of occurrence or the
consequences or both (e.g. by modifying the design or building in safety margins or
procedures)

 reducing uncertainty (e.g. through further research or a feasibility study)

 transferring risk (e.g. through engaging a sub-contractor on a fixed price contract)

 insuring risk (in fact a particular case of risk transfer)

 sharing risk with another party (especially where the other party is able to control the
risk to some extent)

Each option for mitigating a particular risk will be evaluated, assessing:

 likely effect on frequency, consequence and expected value

 feasibility and cost of implementing the option
 any “secondary risks” resulting from the option
 further mitigating actions to respond to secondary risks
 overall impact of each option on the distribution of NPVs

The result of adopting a particular option ought to be to reduce the downward volatility of
the NPVs but in addition it normally either:

 increases the expected NPV, or

 decreases the expected NPV

In the former case, the mitigation option is beneficial and should be built in to the project.
In the second, and more normal, case, judgement will have to be exercised on whether the
mitigation option in question should be adopted.

4 The investment submission

A decision will now need to be taken on whether the project should proceed. The
investment submission, which is to be used as a basis for this decision, should assume that
the best possible combination of mitigation options will be implemented. It should show
the expected NPV (allowing for both upside and downside risk and for an appropriate
contingency margin to cover probabilistic risks which have not been fully analysed) and
the probability distribution of NPVs.

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The residual risks should be fully identified and analysed. Particular attention needs to be
paid in the submission to any remaining risks that could have a serious or catastrophic
effect on the outcome of the project as a whole, even if they have a low or uncertain
probability of occurrence. The method by which it is proposed to finance the project
should be specified, and an analysis provided showing the likely effect on investors after
taking account of expected price inflation, borrowing, tax, etc.

The decision makers will need to pay attention not only to the submission but also to a
range of intangible considerations that are outside the scope of the formal analysis. Such
considerations might include: allowance for any likely bias or possible approximations in
the estimates, “hunch”, knowledge not in the possession of those who have prepared the
submission, last minute developments, doubt about feasibility or quality of
implementation, overall project credibility, etc. They will also consider whether the
upside potential has been estimated realistically. Finally, judgement will be required on
whether, taking all these aspects into account, the project meets the sponsor’s criteria
sufficiently to justify a decision to proceed.

Example

The following sections illustrate a simple process for appraising competing projects and
choosing between them, using RAMP methodology for risk assessment, combined with a
suitable investment model. A practical example of the process is given, together with a
method for deciding whether risk mitigation is financially worthwhile or not.

The following projected cashflows could result from analysing a proposed project:

Scenario A B C D E
Year £000 £000 £000 £000 £000
1 1000 1000 1000 1000 1000
2 300 500 300 200 300
3 400 400 300 300 200
4 400 400 400 300 300
5 400 400 400 300 300
6 — — 400 — 300
Net cash flows 500 700 200 100 200
NPV 292 481 64 54 391
Probability of occurrence 55% 10% 15% 10% 10%

Expected (weighted average) NPV = 155

Hence on 65% of occasions such a project would show a profit but on 35% of occasions it
would show a loss. The loss could be as high as £391,000 but might be even more. On
average a large number of such projects would show a profit.

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The external contractor who will carry out the work is prepared to bear the whole of any
extra development costs arising after year 1 (as in scenarios C and E), provided that the
contract price is increased by £80,000. Is it worthwhile for the sponsor to accept this
offer?

Solution

The various scenarios can be evaluated again, assuming that this new condition applies, as
follows:

Scenario A B C D E
Year £000 £000 £000 £000 £000
1 1080 1080 1080 1080 1080
2 300 500 — 200 —
3 400 400 300 300 200
4 400 400 400 300 300
5 400 400 400 300 300
6 — — 400 — 300
Net cash flows 420 620 420 20 20
NPV 212 401 139 134 188
Probability of occurrence 55% 10% 15% 10% 10%

Expected (weighted average) NPV = 145

The project will now show a profit on 80% of occasions and a loss on only 20%.
Moreover, the “maximum” (mid-point) loss is reduced from £391,000 to £188,000. This
risk profile may well be more attractive than the original one to a sponsor who would find
losses hard to bear. On the other hand, for a large sponsor where the project is one among
many projects, the better expected NPV of the original situation (£155,000 instead of
£145,000) would suggest that the risk should remain unmitigated.

Example

A French-based fashion clothing retailer is considering setting up a new internet subsidiary

to sell its clothing range into the US market. Currently it has no distribution outside
France.

Identify the major risks involved in launching the subsidiary together with ways that these
risks might be mitigated.

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Solution

The major risks involved in launching the subsidiary and ways that these risks might be
mitigated are set out below:

Risk Mitigation
Language Employ people who are bi-lingual.
Web security i.e. risk that data supplied to Employ software firm to advise on
the retailer is not secure. suitable package.
Credit Card Fraud Ditto.
Fashion i.e. the subsidiary may be offering Make sure thorough market research has
the wrong type of clothing for the American been conducted and do not offer “high
market fashion” unless one is certain that it will
sell.
Stock i.e. ensuring there is enough stock to Market research.
meet demand without maintaining an excess
of stock.
Supply i.e. ensuring that the clothes will be Investigate the companies offering third
delivered to the customer within the party delivery services and choose one
promised timescale. that can fulfil the company’s needs.
Returns i.e. how will unwanted goods be Set up a suitable internal system to
handled. monitor returns.
Competition i.e. what are other e-retailers Monitor competition.
doing and how will it impact on this
subsidiary.
Presence i.e. how will customers be Advertise.
attracted to the website and will they
recognise the subsidiary’s name.
Pricing i.e. is the price charged competitive Monitor prices.
with other retailers both on the internet and
in the shops.
Currency i.e. how will movements in It might be possible to hedge the currency,
exchange rates affect the prices the at least in part.
subsidiary can charge for its goods and how
will it affect the profitability of the
company when expressed in Euros.
Market risk i.e. the stock market may regard Explain to investors what the plans are and
the subsidiary as very risky and put a lower what strategies are being put in place to
valuation on the whole group. minimise the risk and maximise the return.

END

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UNIT 10 — DATA
Syllabus objectives

5.1 Discuss the data requirements for determining values for assets, future benefits and
future funding requirements.

5.2 Describe the checks that can and should be made on data.

5.3 Describe the circumstances under which the ideal data required might not be
available and discuss ways in which this problem may be overcome.

5.4 Describe how to determine the appropriate grouping of data to achieve the optimal
level of homogeneity.

1 Data requirements
Actuaries use data in all their work. The main uses are:

 administration
 accounting
 statutory returns
 investment
 financial control, management information
 risk management
 setting provisions
 experience statistics
 experience analyses
 premium rating, product costing, determining contributions
 marketing

The interaction between these functions can be very complex and will vary from
organisation to organisation. Essentially, however, for a given type of work the
underlying data requirements will normally be similar. The overriding principle is that all
these functions should be controlled through one single, integrated data system. However,
this ideal is not always achieved in practice. In a smaller organisation it is easier to ensure
that the data used for different applications are consistent, because it is likely that the same
small group of people will carry out the applications.

For some purposes, data may only be required on a “big picture” basis. Here, data will be
publicly available via published company accounts and statutory returns.

Product providers need data relating to the individual risks that they provide cover for.
The quantity and quality of these data are both important. Without sufficient quantity,
data groupings will either be non-homogeneous or lack credibility. However, even where
there are plenty of data available, poor quality data will mean that any results produced are
not reliable.

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Problems of data quality and quantity can be a result of poor management control of data
recording or its verification processes, or due to poor design of the data systems. This may
not necessarily be a reflection on the current management, as good quality data cannot
necessarily be obtained quickly. After implementing a process for maintaining extensive
records, it may take many years for enough data to be collected for analysis purposes.

The availability of data of good quality and quantity will vary greatly between
organisations and, within organisations, between the different classes of business.

When placing a value on liabilities, for health care, life and general insurers, the prime
information source will be the details given on the proposal form. It is therefore important
that it produces relevant and reliable information for the system. Questions need to be
well designed and unambiguous, so that the proposer will give the full, correct information
and the underwriting department can process the application readily, adding any coding
that is necessary. In particular the result of any medical or occupational underwriting will
need to be added. For general insurance personal lines the composition of the final
premium from various rating factors will be important.

This information (together with any subsequent changes) will need to be held for a number
of purposes, including cross-checking against the claims information at the time of any
claim. This should enable the automatic checking of the validity of the claim and the
updating of the policy information (e.g. termination of cover in the event of a total loss
under a general insurance policy or death under a life insurance policy). The data
requirements will depend on the type of benefits provided.

Another important information source will be the details given on a claim form. Like the
proposal form, it is important that this is designed with the aim of producing information
that can be both analysed accurately and also transferred easily to the computer system.
As well as data relating to current risks covered, it is important to retain the history of past
policy and claim records.

There may be occasions when the actuary does not have full control over the data
available. For example, when valuing benefits under an employee benefit scheme, the
scheme sponsor will usually provide data on the operation of the scheme and the scheme
membership. It will be particularly important to validate this type of data.

Data will be required to place a value on the benefit entitlements of individuals. Data will
be required in respect of individuals who have an entitlement to receive a benefit in the
future and also individuals who are currently receiving benefits. The data will need to be
sufficiently detailed to provide all information that is likely to be financially significant to
the level or timing of future benefits. For example, if a pension is to be provided, the age
of the individual will be significant as it will help to indicate when the benefit may become
payable and when it may cease to be payable. However, if a pension were also to be paid
to a spouse after the death of the member, the existence and age of a spouse of a young
member may not be financially significant as the marital status of the member may change
in the future.

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Any equivalent data used when previously valuing benefits will be useful to the actuary as
it will enable reconciliations to be performed that help to indicate the validity of the
current data. Accounting data may also help in this process.

Where reserves are built up for benefits, a balance sheet and income and expenditure
statement may exist. This will provide information about the total value of the assets held
and perhaps information relating to recent benefit outgo and premium/contribution
income. This information will be useful in verifying other data or in considering the
assumptions to be used. If audited accounts exist, they will enable greater reliance to be
placed on the figures when verifying the data.

To place a value on assets that is reliable and consistent with a value placed on future
benefits, it is necessary to obtain a full listing of the individual assets held. These
individual holdings should then be checked to determine whether they are permitted, or are
subject to valuation restrictions imposed by regulation or legislation.

2 Checks that can be made on data

Whether using data provided by their own organisation or a third party, an actuary will
have to make and check certain assertions about that data. Such assertions include:

 that a liability or asset exists on a given date

 that a liability is held or an asset is owned on a given date

 that when an event is recorded the time of the event and the associated income or
expenditure are allocated to the correct accounting period

 that data is complete i.e. there are no unrecorded liabilities, assets or events

 that the appropriate value of an asset or liability has been recorded

A decision will then have to be made as to how these assertions will be checked and the
level of detail that will be appropriate in checking them. Possible checks could include:

 Reconciliation of the total number of members/policies and changes in

membership/policies, using previous data and movement data.

 Reconciliation of the total benefit amounts and premiums and changes in them, using
previous data and movement data.

 The movement data should be checked against any appropriate accounting data,
especially with regard to benefit payments.

 Checks should be made for any unusual values, for example: impossible dates of birth
or retirement ages or start dates.

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 Consistency between salary related contributions and in-payment benefit levels

indicated by membership data and the corresponding figures in the accounts.

 Consistency between the average sum assured or premium for each class of business
should be sensible, and consistent with the figure for the previous investigation.

 Consistency between investment income implied by the asset data and the
corresponding totals in the accounts.

 Where assets are held by a third party, reconciliation between the beneficial owner’s
and the custodian’s records.

 Full deed audit for certain assets, for example checking the title deeds to large real
property assets.

 Consistency between shareholdings at the start and end of the period, adjusted for
sales and purchases, and also bonus issues, etc.

 Random spot checks on data for individual members/policies or assets.

3 Lack of ideal data

The main circumstances where ideal data are not available are because:

 Data have not been captured at a sufficiently detailed level. For example a benefit
scheme may not analyse membership by whether the employee is a clerical or a
manual worker. Changes in the structure of the membership may have a material
effect on scheme benefits such as early death or accident benefits. Similarly where
life assurance premiums are collected at the door by an agent who calls, only limited
data may be captured on the insurer’s database.

 There may be insufficient data to provide a credible result. A provider may have
recently launched a new product, or branched out into a new target market.
Alternatively the provider may simply be too small to attach any credibility to its own
experience. This is particularly the case with benefit schemes, where very few
employers will be of sufficient size to have credible experience to assess mortality
rates before retirement.

When valuing benefits it may be appropriate to use summarised data instead of detailed
membership data in some circumstances. However, it should be recognised that the
reliability of the values will be reduced, as full validation of the data will be impossible.
Additionally, the summarised data may miss significant differences between the nature of
benefits that have been grouped together. Summarised data is therefore only suitable if
such inaccuracy is recognised by the users of the results of the calculations.
It is also unlikely that summarised data could be used to value options or guarantees that
may or may not apply on an individual basis.

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In some countries there are organisations that collect data from their member offices and
then make available summaries of all the data to their members. For example, in the UK,
the Association of British Insurers collects and collates a wide variety of insurance data.
This cannot be used in place of policy data to establish provisions for a particular policy or
scheme, but could be used to determine bases or be used in product pricing. One of the
best examples is the Continuous Mortality Investigation Bureau of the Institute and
Faculty of Actuaries in the UK, which does a large amount of work on mortality and
morbidity statistics. The volume of data that can be collected from across a whole
industry greatly improves the statistical significance of the resulting analysis.

An insurer participating in an industry-wide scheme has the prospect of being able to

compare its own experience with that of the industry as a whole (or that part of it
represented by the participating insurers) as regards both the overall level and the pattern
of the experience by the categories into which the data are classified. Any significant
differences point to a need for explanation. Since an insurer is likely to be seeking to
expand by attracting business from its competitors, it may be important to have an
indication of the ways in which the characteristics of the business it is seeking may differ
from those of the business it already has.

It may also be possible to obtain data from a reinsurer.

Another source of data would be national statistics.

Example

A life insurance company has written a wide range of unit-linked business for many years.
Two years ago it launched a without-profit regular premium term assurance product. The
contract has a sum assured payable on death, or on the earlier diagnosis of one of a
specified list of critical illnesses.

The company is reviewing the premium rates and profitability of this contract.

Describe the factors that would be taken into account in this review for the mortality and
morbidity assumptions used in determining the premium rates.

Solution

For all assumptions the company will start with the existing assumptions and adjust them
in the light of experience. It will know whether sales have been above or below
expectations, and thus whether it is looking towards a reduction in rates in order to
increase business volumes, or an increase in rates to improve profitability. As the rates
were set without the company having any of its own experience, the pricing basis may not
reflect actual experience.

The company is unlikely to have sufficient of its own mortality or morbidity experience
for this product after 24 months to justify any change in the assumptions. It will be
necessary to review the data used in the pricing process. If this is from industry sources,
then it is possible that updated industry data will be available.

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Mortality, and more particularly morbidity, experience depends on the socio-economic

group of the insured. Consequently it is important to determine whether the market in
which the product is sold is the same as that anticipated in the pricing basis. Any
difference would justify a review of the assumptions.

Critical Illness rates are likely to be derived from reinsurers or from industry sources. It
will be necessary to take any revised rates from reinsurers into account. Reinsurers are
likely to have a view as to how the critical illness market is developing, and may have
changed their outlook for future morbidity rates.

4 Grouping of data
The main aim of risk classification is to obtain homogeneous data. The reduction of
heterogeneity within the data for a group of risks makes the experience in each group more
stable and characteristic of that group, and enables the data to be used more appropriately
for projection purposes. This is important when monitoring claims experience, mortality
experience etc. Any heterogeneity in data groups will serve to distort the results and can
lead to setting provisions that are too big or too small and calculating premiums or
contributions that are incorrect.

Ideally data to be analysed should be split into homogeneous groups, for example, by age
and sex in a mortality investigation. However, where data is scarce, for example numbers
of deaths at young ages, splitting data into homogenous groups may result in data groups
that are too small to enable any credible analysis to be carried out. In such cases data may
need to be combined into groups which are less homogeneous, but which are large enough
to be credible. Whenever data is to be analysed there needs to be a balance between
splitting the data into homogeneous groups and having sufficient data in each group to
enable a credible analysis to be carried out.

There is also a need to carry out sensitivity testing to check that if the data are grouped in a
different way the same results are obtained.

When using industry-wide data, there is potential for distortions arising from
heterogeneity. This is because the data supplied by different organisations may not be
precisely comparable because:

 companies operate in different geographical or socio-economic sections of the market

 the policies sold by different companies are not identical

 sales methods are not identical

 the companies will have different practices, e.g. underwriting or claim settlement
standards

 the nature of the data stored by different companies will not always be the same

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 the coding used for the risk factors may vary from organisation to organisation

Other problems with using industry-wide data may be:

 the data will usually be less detailed, or less flexible, than those available internally
 external data are often much more out of date than internal data
 the data quality will depend on the quality of the data systems of all its contributors
 not all organisations contribute

END

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UNIT 11 — RISK MANAGEMENT

Syllabus objectives

6.1 Discuss the issues surrounding the management of risk.

6.2 Describe the tools that can be used to aid the management of risk.

6.3 Discuss the methods of measuring risk that can be used by the main providers of
benefits on contingent events.

6.4 Describe how risks with low likelihood but high impact might be managed.

6.5 Discuss the use of scenario analysis, stress testing and stochastic modelling in the
evaluation of risk.

1 Issues surrounding the management of risk

This unit considers the issues surrounding the risks that an individual or company chooses
to retain. Unit 3 discusses analysis of risk and methods of transferring risk to another
party. Having decided to retain or acquire certain risks it is necessary to ensure that the
price accepted for the risks taken on is adequate, allows the risk-taker to continue in
business, and contributes to profit.

Evaluating and pricing risk is the key issue. However it is also necessary to ensure that all
risks are actively managed, so that the expected profit materialises. The main tools
available for risk management are:

 diversify the risk away

 implement control measures that reduce the likelihood of the risk event occurring

 implement control measures to ensure that the price paid for the risk is fair

 implement control measures to mitigate the consequences of a risk event that does
occur

Having taken these actions, it is then necessary to determine the amount of capital to hold
against the risks accepted. This might be expressed as a ruin probability over a specified
period, or a ruin probability over the entire run-off of the existing portfolio. The shorter
the period chosen, the lower the ruin probability must be.

When financial products provide benefits on future contingent events, there is little that the
product provider can do to prevent the primary business risk events occurring. General
insurers can contribute to public education campaigns about security of buildings and
reducing the risk of fire, but there is little action that a life insurer or benefit scheme can

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take to reduce its insurance risks. However all companies can implement control systems
to reduce the likelihood of operational risks such as financial fraud.

Providers of benefits on future contingent events need to have a comprehensive approach

to risk management to ensure that they have adequate resources to meet their obligations.
In particular, a well-managed provider will aim to co-ordinate this risk management
process not only to ensure that not only is sufficient capital available but that the capital is
being used efficiently and that the organisation is creating value for shareholders and/or
other stakeholders. Another important aspect is that the risk management programme
should also reduce the total cost of risk i.e. the cost to the entity of all costs incurred to
deal with risk including expected loss costs, disruption to business, insurance premiums,
risk managers salaries, and other items.

2 Tools that can be used to aid the management of risk

The following can be used to aid the management of risk for a financial product provider:

 diversification
 underwriting at the proposal stage — this ensures a fair price is paid for the risk
 claims control procedures — these mitigate the consequences of a risk event that has
occurred.
 management control systems

2.1 Diversification
Risk can be diversified within the following:

 lines of business
 geographical areas of business
 providers of reinsurance
 investments — asset classes
 investments — assets held within a class

Diversification of business lines can be achieved by marketing a wide range of contracts

insuring a wide range of risks. However this would be expensive in terms of
administrative systems, staff training, etc. It also means that all companies are generalists
and there is little scope for niche players in the market. To deal with this disadvantage,
companies can use reciprocal quota share reinsurance, where one company reinsures part
of its business to another in exchange for accepting part of its reinsurer’s business. In this
way each company can concentrate its marketing, sales and administrative effort on its
chosen segment of the market, while still writing a wide spread of risks.

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2.2 Underwriting prior to acceptance of risk

Underwriting generally refers to the assessment of potential risks so that each can be
charged an appropriate premium. Underwriting can be used to manage risk in the
following ways:

 It can protect a provider from anti-selection.

 It will enable a provider to identify risks for which special terms need to be quoted. A
provider may however aim to accept a large proportion of the business it accepts at its
standard rates of premium.

 For substandard risks, the underwriting process will identify the most suitable
approach and level for the special terms to be offered.

 Adequate risk classification within the underwriting process will help to ensure that all
risks are rated fairly.

 It will help in ensuring that claim experience does not depart too far from that assumed
in the pricing of the contracts being sold.

 For larger proposals the financial underwriting procedures will help to reduce the risk
from over insurance.

The underwriting process for a life insurer involves:

 Medical and other evidence

Where the company is at risk on death or sickness under a contract, it will obtain
evidence about the health of the applicant so as to assess whether he or she attains the
company’s required standard of health and if not what their state of health is relative to
that standard.

For annuities and other contracts where there is only a longevity risk, the same could
be done, but with a different emphasis, if the company intends to differentiate
according to the health of the applicant in the terms it offers.

Besides the medical state of health of the applicant, other factors that can affect the
mortality or sickness risk need to be investigated, namely any risks associated with:

– the applicant’s occupation

– the leisure pursuits of the applicant
– the applicant’s normal country of residence

To counter the risk of overinsurance, details of the financial health of the applicant
may be obtained.

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 Interpretation of the evidence

The evidence obtained needs to be interpreted in terms of the standard of health

required by the life insurance company. This will be done by specialist underwriters
employed by the company.

 Specification of terms

Applicants whose state of health reaches the required standard can be offered the
company’s normal terms for the particular contract.

Other applicants will be offered special terms, unless their state of health is such that
the company will not accept them on any terms, in which case they will be declined —
at least temporarily.

The main ways in which the special terms can be specified are as follows:

– An addition may be made to the premium that would have been charged to an
applicant who did meet the required standard, commensurate with the degree of
extra risk.

– A deduction may be made from the benefit, which would have been paid to an
applicant who did meet the required standard, again commensurate with the degree
of extra risk.

– An exclusion clause, to be appended to the contract, which excludes payment of

benefit claims that arise due to specified causes.

Example

A life insurance company’s underwriting process has shown that an applicant has recently
been diagnosed with a particular disease. 90% of individuals contracting this disease die
from it, with death occurring around twenty years from the date of diagnosis. The 10%
who survive the disease cease to show any symptoms within three years from diagnosis.
Discuss the terms that might be offered to the applicant in respect of each of the following
contracts:

(a) a 10-year term assurance

(b) a 10-year convertible term assurance
(c) a 20-year endowment assurance
(d) a whole life assurance
(e) waiver of premium benefit on a pensions contract

Solution

(a) 10-year term assurance — this risk could be accepted at ordinary rates since the
disease should not affect mortality during the life of the contract.

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(b) 10-year convertible term assurance — this risk could be accepted at ordinary rates but
with restrictions imposed on the conversion options if symptoms still exist at the time
of conversion.

(c) 20-year endowment assurance — this risk could be accepted at ordinary rates as the
sum at risk is likely to be small at the time of expected death from the disease.

(d) A whole life assurance — for this risk either an extra premium could be charged or
the sum assured could be reduced to equate the policy to a twenty year endowment.
Or it could be accepted at ordinary rates but with an appropriate exclusion clause
included (although this will be difficult to police). Or acceptance could be deferred
with the suggestion that the applicant takes out a three-year term assurance and
reapplies for the whole life assurance if and when they are clear of the disease.

(e) Waiver of premium benefit — for this risk the correct decision is not obvious from
the information given since we are not told whether the disease impacts health during
the 20 years before expected death. If it does not significantly impact health then
ordinary rates will be appropriate, but if it does then the expected problems will
indicate whether the proposal should be declined or accepted on special terms.

2.3 Claims control systems

Claims control systems mitigate the consequences of a financial risk that has occurred.
They guard against fraudulent or excessive claims. However the costs of implementing
and maintaining a control system must be compared with the benefits gained from it.

For example most general insurers will accept small claims on the basis of a claim form
and a single estimate for the necessary repairs. Above a monetary limit the insurer may
wish to see two or three estimates, including one from a company approved by the insurer.
At a further level the insurer might require that damage is inspected by one of its
employees or agents before remedial work is authorised. For the larger claims the insurer
might appoint a firm of loss adjusters to manage the whole remedial programme on its
behalf.

Another example of a claims control system is the need to manage income protection or
permanent health insurance claims. The claimant needs to have a strong incentive to
return to work. While the claim payments fulfil an important need, it is equally important
that the claimant does not see the additional income as a justification for not working.

2.4 Management control systems

Good management control systems can reduce a provider’s exposure to risk. These
systems include:

 Data recording. It is important that the company holds good quality data on all the
risks it insures, with particular emphasis on the risk factors identified when the
product was designed or when the risk was underwritten. While this cannot change
the provider’s exposure to the business risks underwritten, it can assist in ensuring that

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adequate provisions are established for those risks, and reduce the operational risks
from having poor data.

 Accounting and auditing. Again good accounting and audit procedures cannot change
the risks accepted, but enable proper provisions to be established, regular premiums to
be collected, and the providers of finance to the provider to be reassured as to its
financial position.

 Monitoring of liabilities taken on. It is important to monitor the liabilities taken on by

a company to protect against aggregation of risks of a specific type to an unacceptable
level. Where the acceptance of risks involves the provider in new business strain, it is
important to quantify the amount of new business to ensure that it is within the
provider’s resources. In addition, premium rating may involve cross subsidies from
one type or class of business to another. If the business mix expected in the premium
rates is not achieved in practice the profitability of the contract may be at risk.

 Options and guarantees. Care needs to be taken when offering options and guarantees,
particularly those which appear to have limited value when granted but which could
become valuable if market or other conditions change.

3 Measuring risk
3.1 Asset risks
For investment portfolios, most attention has been devoted to measuring and managing the
risks connected with an active investment approach. This is considered in Unit 16 as part
of investment management.

3.2 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 Unit 25 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.

3.3 Value at Risk

Value at Risk (VaR) generalises the likelihood of underperforming by providing a
statistical measure of downside risk. VaR assesses the potential losses on a portfolio over
a given future time period with a given confidence level. It can be measured either in
absolute terms or relative to a benchmark. Again, VaR is based on assumptions that may
not be immediately apparent. In particular, it is frequently calculated assuming a normal
distribution of returns. If the distribution of returns is “fat-tailed”, or skewed, tracking
error (with its focus on the standard deviations of returns) may be misleading.

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Unfortunately, portfolios exposed to credit risk, systematic bias or derivatives may exhibit
non-normal distributions. The usefulness of VaR in these situations depends on modelling
skewed or fat-tailed distributions of returns, either in the form of statistical distributions or
via Monte Carlo simulations. However, the further one gets out into the “tails” of the
distributions, the more lacking the data and, hence, the more arbitrary the choice of the
underlying probability becomes.

3.4 Expected Shortfall/Tail VaR

Closely related to both shortfall probabilities and VaR are the Tail VaR and Expected
Shortfall measures of risk.

The risk measure can be expressed as the expected shortfall below a certain level:

L
Expected shortfall = E[Max(L – X, 0)] =  
( L  x) f ( x)dx ,

where L is the chosen benchmark level. If L is chosen to be a particular percentile point

on the distribution, then the risk measure is known as the Tail VaR. However, Tail VaR
can also be expressed as the Expected Shortfall conditional on there being a shortfall.

Downside risk measures have also been proposed based on an increasing function of
(L – x), rather than (L – x) itself in the integral above.

Shortfall measures are useful for monitoring a fund's exposure to risk because the expected
underperformance relative to a benchmark is a concept that is relatively easy to
understand.

4 Low likelihood — high impact risks

The risk portfolio analysis described in Unit 3 will have identified a range of high impact
but low probability risks. These are among the most difficult to manage; they are likely to
include both risks related to normal business activities and operational risks. It is
important to manage such risks in a measured way. In particular because credit rating
agencies and regulatory authorities pay significant interest to the ability of a company to
withstand rare events, there is a temptation for management to concentrate unduly on such
risks at the expense of the broad range of risks accepted.

Low probability, high impact risks:

 can only be diversified in a limited way — for example production of a major product
line on two sites diversifies the risk of a total loss of business premises by fire, but has
attendant additional costs if a total loss by fire does not occur

 can be passed to an insurer or reinsurer, usually by some form of catastrophe insurance

or whole account aggregate excess of loss cover (commonly called “stop loss” cover)

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 can be mitigated by management control procedures, such as disaster recovery

planning

Some such risks can only be accepted as part of the consequences of the business
undertaken, and the management issue then becomes how to determine the amount of
capital that it is necessary to hold against the risk event. The techniques of scenario
analysis, stress testing and stochastic modelling discussed below enable this to be done.
Finally a company will have determined its own risk tolerance – for example the ability to
withstand an event that might occur with a 0.5% probability within one year. This means
that the company accepts that it might be ruined by a rarer event, and has decided not to
take such events into account in its risk management.

5 Evaluation of risks
5.1 Scenario analysis
Scenario analysis is a means of evaluating risk where a full mathematical model is
inappropriate. This could be because the risks are not suitable for mathematical
modelling, or because a model would need so many subjective parameters that the value of
using a detailed model is eroded. Scenario analysis is frequently used when evaluating
operational risks. It involves a number of steps:

 Risk exposures need to be grouped into broad categories — all risks involving
financial fraud; all risks involving systems errors, for example. This step is likely to
involve input from a wide range of senior individuals in the organisation.

 For each group of risks, a plausible adverse scenario is developed. The scenario needs
to plausible, otherwise it will not be possible to determine the consequences of the risk
event. The scenario is deemed to be representative of all risk in the group.

 For each scenario, the consequences of the risk event occurring are calculated. Again
this is likely to involve senior staff input. The financial consequences include redress
paid to those affected; the cost of correcting systems and records; regulatory fees and
fines; opportunity costs while any changes are made; etc.

 The total costs calculated are taken as the financial cost of all risks represented by the
chosen scenario.

5.2 Stress testing

The risks that are incurred by extreme market events can be identified and investigated by
the process of financial stress testing. This involves subjecting an asset portfolio or a
block of business comprising both assets and liabilities to extreme market moves by
radically changing the underlying assumptions and characteristics, in order to gain insight
into the portfolio’s sensitivities to predefined risk factors. This pertains in particular to

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asset correlations and volatilities which are often observed to simultaneously increase
during extreme market events. There are two types of stress test:

 to identify “weak areas” in the portfolio and investigate the effects of localised stress
situations by looking at the effect of different combinations of correlations and
volatilities

 to gauge the impact of major market turmoil affecting all model parameters, while
ensuring consistency between correlations while they are “stressed”

A major part of establishing a comprehensive stress testing framework is constructing

stress test scenarios that apply to the specific business. These scenarios should be tailored
to reveal weaknesses in the portfolio structure in terms of risk exposure and sensitivity,
and should thus focus on the risk factors to which the business is most exposed.

5.3 Stochastic modelling

An obvious extension of stress testing is a full stochastic model with all the variables that
give rise to risk being incorporated as probability distributions, and a full set of dynamic
interactions between the variables specified. The model can then determine the capital
necessary to (just) avoid ruin at any desired probability level. Not only is such a model
extremely complex to specify and build, the run times that result from having more than
one, or possibly two, variables simulated by stochastic methods become impractical with
even the most modern computing power.

It is therefore necessary to limit the ideal scope of the model by one ore more of the
following approaches:

 Restrict the duration of the model to two years if the risk criterion is expressed as a
one-year ruin probability. However some parts of the model, such as calculation of
basic policy reserves for life assurance contracts, will still require projections to run-
off.

 Limit the number of variables that are modelled stochastically. Deterministic

approaches can be used for other variables. In particular variables that only have an
adverse effect when they move in one direction can be modelled using deterministic
scenario analysis. For example in a benefit scheme it is increasing longevity that will
put the scheme under stress, rather than deteriorating mortality.

 Carry out a number of runs with a different single stochastic variable, followed by a
single deterministic run using all the worst case scenarios together. This will
determine the effect of interactions between the various variables.

It is important to remember that the results are only as good as the model used.

END

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UNIT 12 — MODELLING
Syllabus objectives

7.1.1 Describe the approaches available to produce the solutions.

7.1.2 Describe the use of actuarial models to support the methodology used in terms of:

 the objectives of and requirements for building a model

 the basic features of a model required to project future cash and revenue flows

 the use of these models for:

– pricing or setting future financing strategies

– risk management

– assessing the capital requirements and the return on capital or the funding
levels required

– assessing the provisions needed for existing commitments to provide

benefits on contingent events

– pricing and valuing options and guarantees

 how sensitivity analysis of the results of the models can be used to help
decision making

1 Possible approaches to solving actuarial problems

There are various approaches that can be taken to produce the solution to an actuarial
problem. Simple problems can have a simple solution that is arrived at by some
straightforward mathematics, for example calculating the yield on a fixed interest asset, or
the present value of a series of known cash flows.

However the majority of problems that require actuarial skills involve taking a view on
uncertain future events. It is possible to take a view on various parameters, such as future
economic conditions, future mortality rates, or the amount of business that a provider
might write in future, and produce a singe answer that is appropriate in these best estimate
conditions. If this is done then the communication of the solution to the client needs
particular care, because of the uncertainties in the underlying assumptions.

In these circumstances the client is likely to wish to know the variability of the answer
provided, should circumstances not be as estimated. To assess the effects of varying the
assumptions used in producing the answer, it is normally necessary to use an actuarial
model of future events.

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A model can be defined as “a cut-down, simplified version of reality that captures the
essential features of a problem and aids understanding”. The final phrase in this definition
recognises the importance of being able to communicate the results effectively. Modelling
requires a balance to be struck between realism (and hence complexity) and simplicity (for
ease of application, verification and interpretation of results).

When faced with an actuarial problem, there are various approaches to modelling:

 a commercial modelling product could be purchased

 an existing model could be reused, possibly after modification
 a new model could be developed

The merits of each of these approaches will depend on amongst other things:

 the level of accuracy required

 the “in-house” expertise available
 the number of times the model is to be used
 the desired flexibility of the model
 the cost of each option

Other issues include making sure that the model used is fit for the purpose for which it is
being used. This is particularly relevant when a model is being purchased from an
external provider or when an existing model is being reused for a different purpose.

There are now a large number of stochastic asset models in existence, in both the public
and private domains. There are fewer models available for other variables, such as
mortality and voluntary discontinuance, but these are starting to be developed.

The prime objective in building a model is to enable a provider of financial products to be

run in a sound financial way. An actuary will normally be giving advice to the provider to
achieve this aim. To this end, models will be used to assist in the day-to-day work of the
provider and to provide checks and controls on its business.

2 Objectives of and requirements for building a model

Models will need to satisfy the following requirements:

 The model being used must be valid, rigorous enough for its purpose and adequately
documented.

 The model chosen should be capable of reflecting the risk profile of the financial
products, schemes, contracts or transactions being modelled adequately.

 The parameters used must allow for all those features of the business being modelled
that could significantly affect the advice being given.

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 The inputs to the parameter values should be appropriate to the business being
modelled and take into account any special features of the provider and the economic
and business environment in which it is operating.

 The workings of the model should be easy to appreciate and communicate. The
results should be displayed clearly. The model should exhibit sensible joint behaviour
of model variables.

 The outputs from the model should be capable of independent verification for
reasonableness and should be communicable to those to whom advice will be given.

 The model, however, must not be overly complex so that either the results become
difficult to interpret and communicate or the model becomes too long or expensive to
run, unless this is required by the purpose of the model. It is important to avoid the
impression that everything can be modelled.

 The model should be capable of development and refinement — nothing complex can
be successfully designed and built in a single attempt.

 A range of methods of implementation should be available to facilitate testing,

parameterisation and focus of results.

It will be necessary to decide between deterministic and stochastic modelling processes. A

deterministic model is more readily explicable to a non-technical audience, since the
concept of variables as probability distributions is not easy to understand. It is clearer
what economic scenarios have been tested. The model is usually easier to design and
quicker to run. The disadvantage is that it requires thought as to the range of economic
scenarios that should be tested.

A stochastic model tests a wider range of economic scenarios. The programming is more
complex and the run time longer, but the benefit is in the quality of the result. It does
depend on the parameters that are used in any standard investment model. Stochastic
models are particularly important in assessing the impact of financial guarantees.

In many cases the problem can be solved by a combination of stochastic and deterministic
modelling. Variables whose performance is unknown and where the risk associated with
them is high might be modelled stochastically, while other variables can sensibly be
modelled deterministically. For example a model for pricing an investment guarantee
attached to a life insurance policy might use a stochastic investment model, but would be
unlikely to model fluctuations in mortality rates other than deterministically. This is
because it is normally self-evident which direction of movement in mortality rates would
give rise to financial difficulties.

In all cases the dynamism of the model is vital. Rules need to be determined as to how the
various features would interact in different circumstances. For example how life assurance
bonus rates would vary with fixed interest yields or how unemployment rates would vary
with economic conditions. These interactions are usually much more important than the
type of model.

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Considerable actuarial judgement may be required in choosing and using the model and in
setting the parameters and interactions between the different features.

3 Basic features of a model required to project future cash

and revenue flows
An actuarial model needs to allow for all the cash flows that may arise. These will depend
on the nature of the financial products, schemes, contracts or transactions being modelled
and any discretionary benefits they carry.

It also needs to allow, where appropriate, for the cash flows arising from any supervisory
or commercial requirement to hold reserves and to maintain adequate solvency capital.

The cash flows need to allow for any interactions, particularly where the assets and the
liabilities are being modelled together.

Where the business being modelled includes options, for example an option to take out a
new term assurance contract without providing further evidence of health, the potential
cash flows from such options and the take-up rate need to be allowed for.

In some cases there is a need to use stochastic models and simulation, for example, when
assessing the impact of financial guarantees or to allow for investment mismatching risks.

The time period for calculating the cash flows in the projection needs to be chosen bearing
in mind that:

 The more frequently the cash flows are calculated the more reliable the output from
the model, although there is a danger of spurious accuracy.

 The less frequently the cash flows are calculated the faster the model can be run and
results obtained.

Deterministic modelling could involve the following steps:

 Specify the purpose of the investigation.

 Collect, group and modify data.

 Choose the form of the model, identifying its parameters and variables.

 Ascribe values to the parameters using past experience and appropriate estimation
techniques.

 Construct a model based on the expected cash flows.

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 Check that the goodness of fit is acceptable. This can be done by running a past year
and comparing the model with the actual results.

 Attempt to fit a different model if the first choice does not fit well.

 Run the model using estimates of the values of variables in the future.

 Run the model several times to assess the sensitivity of the results to different
parameter values

Stochastic modelling could involve the following steps:

 Specify the purpose of the investigation.

 Collect, group and modify data.

 Choose a suitable density function for each of the variables to be modelled

stochastically.

 Specify correlation between variables.

 Construct a model based on the expected cash flows.

 Check the goodness of fit is acceptable. This can be done by running a past year and
comparing the model with the actual results.

 Attempt to fit a different model if the first model does not fit well.

 Run the model many times, each time using a random sample from the chosen density
function(s).

 Produce a summary of the results that shows the distribution of the modelled results
after many simulations have been run.

Stochastic and deterministic approaches can be combined in a single model in various

ways. For example in a model to assess the likely variability in general insurance claims
experience, there are three ways in which a model may be applied:

 Determine the number of claims stochastically and associate with a deterministic mean
claim cost. Ideally the claim numbers would be divided into various homogeneous
groups in terms of claim size.

 Determine the claim amounts stochastically for the expected number of claims.

 Determine both claim amounts and numbers stochastically, using a collective risk
model.

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4 Use of models
4.1 Pricing and setting future financing strategies
A model could be developed to determine a premium or charging structure for a new or
existing product that will meet a life insurance company’s profit requirement.

The underlying business being modelled will typically comprise a very wide range of
different policies, and these will need to be brought together into a manageable number of
relatively homogeneous groups. The groupings need to be made in a way that each policy
in a group is expected to produce similar results when the model is run. It is then
sufficient for a representative single policy in each group to be run through the model, the
result to be found, and for this result to be scaled up in order to give the result of the total
set of policies in the group. The representative single policy in a group is termed a “model
point” and a number of such “model points” can then be used to represent the whole of the
underlying business.

A number of model points will be chosen to represent the expected new business under the
product. In the case of an existing product, the profile of the existing business, modified
to allow for any expected changes in future, can be used to obtain the model points. For a
new product, the profile of any similar existing product combined with advice from the
company’s marketing department would be used.

For each model point, cash flows would be projected, allowing for reserving and solvency
margin requirements, on the basis of a set of base values for the parameters in the model.
The net projected cash flows will then be discounted at a rate of interest, the risk discount
rate:

This could be a rate that allows for:

 the return required by the company; and

 the level of statistical risk attaching to the cash flows under the particular contract, i.e.
their variation about the mean as represented by the cash flows themselves

The level of statistical risk could be assessed:

 In some situations analytically, by considering the variances of the individual

parameter values used.

 By using sensitivity analysis, as described below, with deterministically assessed

variations in the parameter values.

 By using stochastic models for some or all of the parameter values and simulation.

 By comparison with any available market data.

Alternatively a stochastic discount rate could be used.

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In theory, a separate risk discount rate should be applied to each separate component of the
cash flows, as the statistical risk associated with each component will be different. In
practice a single risk discount rate is commonly used, bearing in mind the “average” risk
of the product.

The premium or charges for the model point can then be set so as to produce the profit
required by the company.

The premiums, or charges, produced need to be considered for marketability. This might
lead to a reconsideration of:

 The design of the product, so as either to remove features that increase the risks within
the net cash flows, or to include features that will differentiate the product from those
of competing companies.

 The distribution channel to be used, if that would permit either a revision of the
assumptions to be used in the model, or a higher premium or charges to be used
without loss of marketability.

 The company’s profit requirement.

 The size of the market.

 Whether to proceed with marketing the product.

The net cash flows in respect of the model points, appropriately scaled up for the expected
new business under the product, will be incorporated into a model of the business of the
whole company. It is possible for the desired level of profitability to be reached in
aggregate, without requiring every single model point to be profitable in its own right. If
certain model points are unprofitable the aggregate profitability of the business is then
exposed to changes in mix and volume of the contracts sold.

The actuary can assess the impact on capital management of writing the product, by
observing the modelled amount and timing of cashflows. If capital is a problem, this may
lead to a reconsideration of the design of the product so as to reduce or amend the timing
of its financing requirement.

Once acceptable premiums or charges, have been determined for the model points,
premiums or charges for all contract variations can be determined.

For a benefit scheme, the equivalent to determining the price for a product is setting the
future financing strategy, and similar modelling techniques can be used. The existing
membership can be divided into categories and represented by a number of model points.
Similar potential new members can be represented, perhaps by a single model point at the
average entry age and salary.

A potential financing strategy is determined, in terms of both the amount and timing of
future contributions. The cash flows from the existing assets and future contributions can

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be modelled, as can the liability cash flows, taking all the possible decrements into
account.

Unlike an insurance company, a benefit scheme can show a deficit at a point in time —
that is the value of accumulated assets does not exceed the value of accrued liabilities,
provided that there is a sponsor with a good enough covenant to make good the shortfall.
However the scheme does need to be solvent to the extent that it has sufficient assets to
meet benefit outgo as it falls due. A well designed model will check this feature as well as
determining the discounted value of asset and liability cash flows.

Considerations such as the choice of risk discount rate, and the need to test sensitivities to
changes in conditions are all similar to those in product pricing.

4.2 Risk management

Cash flow models are used in risk management to determine the amount of capital that it is
necessary to hold to support the risks retained by a financial institution. The various
modelling approaches are discussed in Unit 11, section 5.

As well as the full corporate model to assess capital requirements, models of specific risks
can be used to determine the extent of a risk event that will occur at a given probability,
even if a full stochastic model is too slow, too complex, or otherwise not used. For
example a company that is targeting being able to withstand a 0.1% probability of ruin
needs to know what equity market fall to test in a deterministic scenario.

A standard equity market stochastic model can be used and calibrated to historic
performance of the market being considered. By running the model several thousand
times and ranking the results, the equity fall that gives the one in a thousand worst result
can be found.

4.3 Assessing the capital requirements and the return on capital or

the funding level required

The net cash flows for the model points described in the section on pricing above can be
grossed up for the expected new business and used to assess the amount of capital that will
be required to write the product, either on a regulatory or an economic basis. To this can
be added any one-off development costs to the extent that they are not amortised and
included in the cash flows used. This gives the total capital requirement and can be
compared with the profits expected to emerge from the product so as to determine the
expected return on that capital.

4.4 Assessing the provisions needed for existing commitments to

provide benefits on future financial events

The normal procedure for determining life assurance or pension scheme liabilities is to
value the benefits for each policy or scheme member individually. In many territories this
may be required by legislation or regulation. Consequently for published results there is
little scope for using model points. However, before finalising a published basis, many

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“what if” questions might be asked. These could be answered by running a model of the
business. For smaller schemes or sections of a company’s business it might be just as
quick to run the whole business to answer the question and eliminate the model risk, given
the current speed of computers.

As part of assessing a realistic provision it is necessary to consider the effect of changes in

economic scenarios. For example, using a stochastic model of possible asset movements,
a provision that would be adequate in all but a small proportion of scenarios can be
determined.

4.5 Pricing and valuing options and guarantees

In most cases the options and guarantees that give a provider of benefits on future
financial events cause for concern are those that are dependent on future investment
returns, or an investment value (yield or capital value) at some future point in time.
Because of the uncertainty, a stochastic investment model should be used to assess the
provisions necessary for such guarantees.

If future returns exceed a certain level, or if a value or index is above (or below) a fixed
value at some future point, there will be no cost to the company. But if they are below that
level, there will be a cost, which increases as returns reduce. Hence a range of future
investment scenarios should be tested.

Example

A unit-linked life assurance policy guarantees to pay a maturity value equal to the sum of
premiums on the chosen maturity date, or the value of units allocated if greater. At all
other times the surrender value is based on the value of units.

Discuss the steps involved in assessing the provision to be made for the cost of this
guarantee.

Solution

The steps involved are:

 Choose a stochastic asset model — a complex model gives better results but takes
longer to run.

 Determine assumptions — particularly unit growth rate mean and volatility.

 Determine consistent deterministic assumptions for mortality and surrender rates and
future expenses.

 Consider dynamic links between assumptions — e.g. lapse rates to unit values.

 Choose a time period — probably annual for efficient running.

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 Determine appropriate model points for the portfolio.

 The model will project the unit values to maturity, allowing for future premiums and
all decrements.

 This will be done for a large number of randomly generated investment scenarios —
say between 1,000 and 5,000.

 For each scenario and each model point, the projected unit value will be compared
with the guaranteed maturity value, and the cost for that particular scenario and model
point determined.

 The projected costs are discounted to the present, scaled up by the appropriate factors,
and summed across all model points.

 The average across all scenarios is the expected cost of the guarantee

 The variability should be assessed by looking at the quartiles and 5th/95th percentiles,
when the results are ranked.

 For reserving purposes an appropriate ruin probability needs to be chosen. Perhaps 1

in 100, in which case the reserve is the 99th percentile.

5 Sensitivity analysis
The results from the models depend on the model itself and the values assigned to the
parameters in the model. Models should not be treated as black boxes the output of which
is assumed to be correct.

The use of a stochastic model goes some way to illustrating the potential variability of the
experience, but the results that it produces are still dependent on the accuracy of the model
and its parameter values. In the case of a deterministic model, the potential uncertainty of
the results is greater, because fewer scenarios are tested.

The re-running of a model (deterministic or stochastic) with different, but feasible,

parameter values will produce alternative results and hence help to illustrate the potential
deviations. The re-running with a series of different sets of parameter values, perhaps
chosen from a probability distribution for such values, will help to illustrate the likely
range in which actual experience may lie, perhaps as far as creating a probability
distribution for this experience.

For example, consideration of the effect of a change in the membership profile of a funded
pension scheme may be needed to illustrate the extent of potential variability in future
contributions if the model used is based on a stable membership profile.

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There is the possibility of model error if the model developed is not appropriate for the
financial products, schemes, contracts or transactions being modelled. Checks of goodness
of fit will be needed to assess the suitability of the model.

The effect of mis-estimation of parameter values can also be investigated by carrying out a
sensitivity analysis. This involves assessing the effect on the output of the model of
varying each of the parameter values. When doing this any correlation between different
parameters should be allowed for.

In the case of a model used for pricing, the results from the sensitivity analysis will help to
assess the margins that need to be incorporated into the parameter values. In the case of
models used to assess return on capital and profitability of existing business, the results
will enable the actuary to quantify the effect of departures from the chosen parameter
values when presenting the results of the model to the company.

The statistical risk associated with the parameter values can be allowed through the risk
element of the risk discount rate. An alternative would be to use a predetermined discount
rate and then assess the effect on the results of the models of statistical risk.

Where a probability distribution can be assigned to a parameter, it may be possible to

derive the variance of the profit or return on capital analytically. More generally, a
sensitivity analysis, as described above, can be carried out. Whichever of these two is
used, they will again help in assessing margins or in quantifying the effect of departures
from the chosen parameter values when presenting the results of the model.

END

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UNIT 13 — ASSUMPTION SETTING

Syllabus objectives

7.2 Describe the principles behind the determination of assumptions as input to a model
relevant to producing a specific solution having regard to:

 the types of information that may be available to help in determining the

assumptions to be used

 the extent to which each type of information may be useful, and the other
considerations that may be taken into account, in deciding the assumptions

 the level of prudence in the assumptions required to meet the objectives of the
client

1 Setting assumptions
As in all actuarial work, when setting assumptions it is important to:

 Consider the use to which the assumptions will be put. For example is it to price or
cost a new financial contract or transaction or to estimate the provisions that need to
be held to meet future liabilities?

 Take particular care over the choice of the assumptions that will have the most
financial significance.

 Achieve consistency between the various assumptions.

 Consider any legislative or regulatory constraints.

 Consider the needs of the client.

1.1 Data
Historical data is likely to be a primary source of data used in determining assumptions
about future experience.

In determining an assumption for future investment returns, past data on dividend yields
on equities and on the total returns on relevant classes of investment may be useful.
Where dividends are linked to an inflation index, past data on that index will be useful.

Past data on salary levels in a particular country, industry or company may be useful when
making an assumption about future levels of salary growth. The history of an inflation
index may also be useful in determining an assumption for future benefit growth that is
linked either fully or partially to that inflation index.

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Historical data can also be helpful when choosing demographic assumptions. For
example, historic levels of mortality in a country, industry or company may help choose
assumptions for the number of individuals who will survive to receive pensions or for the
extent to which contingent benefits will be payable. In many countries this data will have
been analysed and used to produce a decrement table. Past data can also be used to project
future improvements in mortality.

Similarly past data can be used when determining the probability of individuals leaving
employment, becoming ill, retiring, being married, etc.

Current data may also be of use when determining assumptions. The relationship between
current yields for fixed and index-linked bonds may provide some indication of the
market’s view of future levels of the inflation index to which the bonds are related. Policy
statements by Governments or controlling banks may also be useful when making
assumptions about economic factors. A scheme sponsor may be able to provide
information on planned future salary increases or likely future rates of withdrawal.

In some instances, assumptions may be defined in regulations or legislation.

1.2 Using past data

It is unlikely to be sensible to take an average rate from past data and assume that it will be
appropriate for projecting future experience. Past data does not provide the answer as to
what will happen in the future, but simply provides information that can be considered
when determining the most likely future experience.

The social and economic conditions are likely to have changed over any period of history.
The actuary therefore needs to consider the conditions that will apply in the future period
to which the projections will relate and how those conditions will lead to differences from
the past data that is being used.

The relevance of past data to future projections must also be balanced against the need for
sufficient data for its analysis to be statistically credible. In making a judgement about
future experience this conflict between credibility and relevance must be managed.

When using past data it is necessary to consider how to deal with:

 abnormal fluctuations
 changes in the experience with time
 random fluctuations
 changes in the way in which the data was recorded
 potential errors in the data
 changes in the balance of any homogeneous groups underlying the data
 heterogeneity with the group to which the assumptions are to relate

Economic data fluctuates with changes in economic and fiscal policy as well as with the
general economic cycle. Past data for investment returns, salary levels and dividend yields
in most countries fluctuate significantly over an extended time-frame. It could be thought

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that economic and fiscal changes mean that most past data is irrelevant and so only data
that relates to a period after any recent significant change can be used. However, this
would reduce the credibility of the data and increase the effect of any random fluctuation.
It is therefore necessary to use the earlier data and to try to strip out the fluctuations that
relate to economic and fiscal conditions that differ from those that exist currently.

Past levels of an index to measure price inflation usually fluctuate significantly and are
often a useful indicator of the economic conditions that existed. They are therefore
unlikely to be very useful in determining an assumption for future levels of inflation.
Current index values may therefore be a better guide to future levels of inflation. For
example, Government projections and the “risk-free” real returns indicated by the current
yields on long-term index-linked bonds could be used.

Past data for price inflation can be very useful in determining other economic assumptions,
as conversion of past economic data into real terms will often remove much of the
fluctuation. In the UK past data for real levels of dividends and salaries fluctuates
significantly less than the nominal data.

Making any further adjustment for economic or fiscal changes is difficult to do other than
subjectively. Dividend levels could be adjusted to allow for changes in taxation applying
to those dividends. However, an explicit adjustment may be spurious, as there may be
changes to the taxation of companies or individuals that have a more significant effect.

Much of the demographic data will also be affected by economic changes. Again explicit
adjustment is difficult and so judgement and analysis of fluctuations and trends will be
important.

Mortality data is mainly affected by medical advances. Past data should be considered
with this in mind. This is likely to result in significant emphasis being placed on the most
recent data with consideration of past trends and their underlying reasons being important
in determining the extent of future change.

It is important that the past data used is relevant to the group of individuals about whom
assumptions are to be made. Levels of salary growth and mortality, for example, usually
differ by type of employment or social class. Ideally the past data would be split into
homogeneous groups to reflect such differences. However in practice the information
necessary to split the data reliably is unlikely to be available, and splitting the data would
result in a significant reduction in credibility. Therefore past data will usually need to be
adjusted in a subjective manner to allow for differences in the characteristics of the
individuals concerned.

In adjusting past data it is important to recognise that the past data may give false results
due to changes in the balance of homogeneous groups over time. For example, past levels
of salary growth may reflect a change in the overall composition of a workforce (for
example production line workers being replaced by mechanisation) rather than just the
changes in real salary levels for individuals.

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Over time, statistics produced by the State or data recorded by companies may change.
Such changes distort the past data and could lead to inappropriate assumptions unless
these changes are recognised.

Data errors will also cause distortions but may not be as easy to recognise as changes in
the ways of recording the data. Generally, the management and verification of data
recorded by companies has improved significantly as the capability of computers has
improved. Older data may therefore carry a greater risk of data error, perhaps to an extent
that outweighs the usefulness of having more data.

1.3 Standard tables

In some countries past data has been analysed on a national or industry level. The most
common data for such analyses relates to mortality and morbidity. Countries may analyse
the whole population’s experience based on censuses. One disadvantage of census data is
that it includes all lives, and not just the restricted population that effect insurance
contracts. Thus census data generally includes lower socio-economic groups that distort
the experience of lives effecting insurance contracts.

In the UK the Institute and Faculty of Actuaries has established the Continuous Mortality
Investigation Bureau, which produces mortality tables based on experience provided by
participating insurance companies. The CMI Bureau does much statistical analysis of the
data including, for example, projecting mortality improvements for the experience of
annuitants.

When using standard tables, the same considerations need to be taken into account as
when using the company’s own past experience data. In particular whether the data is
relevant to the intended population at which the product is marketed, and whether
adjustments need to be made to the data to reflect continuation of past historical trends.

2 Purpose
When considering the assumptions to use to project future experience, the actuary needs to
consider the purpose for which the assumptions are to be used and the significance of each
assumption in the overall result. This helps assess the degree of accuracy required and
hence the extent to which it is necessary to try to remove distortions from data. It also
helps judge whether the assumption should reflect the best estimate of the future
experience or whether it is appropriate to reflect any uncertainty about future experience
by an overstatement or an understatement within the assumption.

Where assumptions are used to place a capital value on future cashflows, it is usually
unnecessary to make a judgement about the accuracy of each assumption. Instead it is
necessary to determine that the overall value resulting from the combination of
assumptions is appropriate. However, where the individual cashflows are important, it
may be necessary for the accuracy of each assumption to be assessed.

Consideration of the potential financial significance of errors in the assumptions also helps
assess the degree of accuracy required, the extent of margins necessary, or the level of risk

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being taken. For example when acting as expert witness to determine a fair compensation
settlement between two parties, it is important that the assumptions used are the actuary’s
best estimate of the future experience. Under- or over-statement will give one party a
direct financial advantage at the expense of the other. Consequently each party will have a
preference for which side of “best estimate” they would like to see each assumption.

3 Implicit assumptions
It is necessary to be aware of implicit assumptions within a model, and consider the effects
of these. For example the funding method for an occupational pension scheme may
assume that:

 new members continue to join or new policies continue to be written and therefore the
age/sex distribution of a population will be maintained

 no new entrants will join or no new policies will be written and so the existing
population should be treated as a closed group

4 Margins
The assumptions will be estimates of the expected values for the parameters. Where a
cash flow model is being used to price a product, the risk to the provider from adverse
future experience could be allowed for by:

 adjusting the risk element of the risk discount rate

 using a stochastic discount rate
 applying margins to the expected values

In pricing a product, a profit requirement will need to be incorporated, as it is reasonable

to suppose that the owners of the provider decide where to invest by comparing the returns
offered by different projects, relative to the risks that are run.

Not all products are equally risky. The provider should view itself as an investor like any
other when it considers the risks of a new product, as in the long run the profits emerging
from the company are the profits emerging from the products that it sells. A change in the
mix of business, for example away from old and safe contracts towards new and
innovative contracts, would change the market’s evaluation of the provider’s risks.

Design and launch of a financial product is a project, and the features of project
assessment and project management described in Unit 9 are just as appropriate in these
circumstances.

The following features can increase the risks in a product design:

 lack of historical data

 high guarantees

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 policyholder options
 overhead costs
 complexity of design
 untested market

It is not easy to assess these risks, and it is even harder to say what effect they should have
on the risk discount rate.

A profit criterion is often a single figure that tries to summarise the relative efficiency of
contracts. By applying a profit criterion to different contracts and then ranking the results
in order, it may be possible to determine which contracts makes most efficient use of a
company’s capital.

The methods of quantifying profitability include:

 net present value

 internal rate of return
 discounted payback period

For example, a possible profit criterion for an insurer might be based on the net present
value of profits emerging from each of its product lines as a pre-determined proportion of
the distribution costs. Such a criterion reduces the bias towards products with high
commission rewards in the distribution system.

Example

A member of a defined contribution pension scheme, where the member has a choice of
investment funds, has requested an estimate of the pension that may be secured from the
scheme at normal retirement age.

(i) List the assumptions that need to be made in determining the estimate.

(ii) You have been asked to draft a letter to be sent to the member with the result of the
calculation. Outline the points you would make in the letter including comments on
the effect of the assumptions that have been made.

Solution

(i) The following assumptions need to be made in determining the estimate:

 the investment return on assets held

 the amounts of future contributions
 the annuity rate that will apply at retirement including allowance for payment
options such as
- inclusion of a spouses pension
- having an escalating pension
- different frequencies of pension payment
- guaranteed minimum period of pension payment

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 the expenses of the contract

 the proportion of fund that will be taken as cash at retirement
 salary growth
 future inflation
 any legislative constraints on the assumptions

(ii) The points to be covered in the letter include:

 That the investment return assumptions are critical. Include a comment on the
impact on the outcome of a change of 1% in either direction in the return each
year in the period to retirement.

 That the return will depend on class of assets the monies are invested in with a
high expected return from risky assets such as equities compared to lower risk
assets such as bonds.

 A comment that the assumption chosen in the calculation is appropriate to the

asset classes held under the contract, but that there is no certainty that this return
will be achieved.

 Comments about the probability of various future contribution patterns e.g.

fixed percentage of salary, fixed monetary amount, and fixed duration.

 A statement that the calculation assumes that the individual will survive to
retirement and details of the benefit that will be provided if he dies before
retirement.

 The pension conversion terms cannot be known in advance with any certainty,
but they will probably depend both on the outlook for future life expectancy at
the time and on the investment return available to insurers on a matching asset
class i.e. bonds. The bonds may be fixed interest or index linked depending
upon the pension increase rate selected.

 An illustration of the impact that say, a 1% difference in bond rates would have
on annuity rates.

 Comments on the options relating to the annuity.

Throughout the letter the uncertainty in the results of the calculation should be
emphasised. It should be mentioned that some greater certainty could be achieved by
investing in assets that match the annuity throughout the duration of the contract.

Example

A life insurance company is one of the market leaders in term assurance in the country in
which it operates. The existing policyholders are 80% male and 20% female. Both
genders comprise 90% non-smokers and 10% smokers.

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This mix has been constant for many years.

In keeping with the other major companies in this market, a non-smoker is defined to be a
person who has not smoked any tobacco product for a period of at least three years.
Because of the mix of business, the pricing mortality assumption is set for male non-
smokers. Females are assumed to have the same mortality as a male three years younger
and smokers are assumed to have the same mortality as a non-smoker five years older.

(i) List the possible sources of data that could be used by the company to set its pricing
mortality assumption and describe how the data would be used.

(ii) The company is considering altering its non-smoker definition by reducing the three
year period to one year.

Discuss the differences this would make to the pricing basis by considering the
following categories of people:

 non-smokers, including those who gave up smoking more than three years ago
 those who gave up smoking between three years and one year ago
 smokers, including those that gave up less than one year ago

Solution

(i) The main sources of data are as follows:

 the company’s own data

 the company’s reinsurers
 industry compiled data if available
 any national statistics
 statistics from other countries if there is not sufficient information in the home
country

If the company’s own data is sufficient then this would be the best source of data.

If the period of any mortality investigation needs to be quite long to get sufficient
data, then care will need to be taken to ensure that the data remains homogeneous.
The mix of business has been relatively constant over many years. If the data are
not sufficient to develop a company specific mortality table, then the company data
could be used to develop adjustments to any industry or national mortality tables.
Industry tables are preferable.

With anything more than the simplest of adjustments to any standard tables, it will
be necessary to ensure that the smoothness and fundamental shape of the standard
table is not distorted without there being sufficient data to justify it.

In all the above the advice of the company’s reinsurers would be sought.

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(ii) There are three categories of people:

A — non-smokers including those who gave up more than 3 years ago (qn)
B — those that gave up between three and one year ago (q3)
C — smokers including those that gave up less than a year ago (qs)

One might expect the relative mortality of these groups to be qs > q3 > qn.

The existing definition means that “non-smoker” only contains group A and
“smoker” contains B and C. The proposed definition means that “non-smoker”
contains groups A and B, whilst “smoker” contains C only.

Non-smoker mortality moves from qn to a weighted average of qn and q3, so using

the above mortality relationship the new non-smoker mortality would be expected to
worsen.

Smoker mortality moves from a weighted average of q3 and qs to qs. So, using the
above mortality relationship, the new smoker mortality would also be expected to
worsen.

This would mean, all else being equal, that the new non-smoker rates would worsen
and so would not be attractive to category A people. However, they would be
attractive to category B people in the market. This would mean the relative weights
between A and B would move more towards B than simply analysing the existing
policyholder mix.

Some existing policyholders in category B, currently on smoker terms, might lapse

their policies and take out new policies on the non-smoker terms. Again, all else
being equal, smoker terms would be less attractive to category C people as better
rates could be gained elsewhere in the market.

The result would be for the company to corner the market for category B people.

To develop a pricing basis for this change, it will be necessary to re-perform the
mortality investigation, re-defining the smoker, non-smoker population. An
adjustment would need to be made for the fact that the company will get a greater
market share for the category B people.

END

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2016 Expenses Subject CA1

UNIT 14 — EXPENSES
Syllabus objectives

7.3.1 Describe the types of expenses that the providers of benefits on contingent events
must meet.

7.3.2 Describe how expenses might be allocated when pricing products, schemes,
contracts or other arrangements.

1 Types of expenses
The expenses incurred by an organisation providing benefits on future financial events can
be divided between fixed and variable expenses. Some expenses (such as building
maintenance) may remain relatively fixed in real terms. Others will vary directly
according to the level of business being handled at that time. These may be linked to the
number of policies or claims or the amount of premiums or claims.

There is a third category of expenses that is essentially fixed, but that can vary in large
amounts from time to time. Within this category would be a senior management team that
would normally be a fixed expense but would be changed if the structure or business of the
company changed significantly. Similarly a declining operation might be able to sub-let a
whole floor of its office premises, when it becomes small enough. Staff related expenses
might remain fixed in real terms in the short term. In the longer term staff costs (and
accommodation costs) will vary to meet changing levels of new and existing business,
changes in services provided, and the degree of automation used to provide those services.
Isolating variable expenses is particularly important in assessing the contributions needed
to provide benefits on future financial events.

The expenses incurred by a benefit scheme may differ from those described above, as the
scheme may have none of the fixed overheads such as building maintenance or rent. It is
possible that much of the work of the scheme, such as administration, legal advice,
actuarial advice or investment management is delegated to third parties who charge a fee
for the service. Where such services are provided in-house, this may be done by the
sponsor’s employees and so the costs will form part of the sponsor’s total overheads.

2 Expense allocation
Some expenses can be identified directly as belonging to a particular class of business.
Others do not have a direct relationship to any one class of business. These need to be
apportioned between the appropriate classes.

Expenses form an important component of the total outgo analysed in internal

management accounts and financial plans. Hence, expenses need to be allocated to
different types of business in as realistic a manner as possible.

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Direct expenses may arise from a department dealing purely with one class of business, in
which case the expenses relating to that department can immediately be allocated to the
relevant class. If direct expenses arise from areas dealing with more than one class of
business then time sheets can be kept (either for a period or permanently) to help split
costs between classes.

The indirect expenses are harder to allocate. By definition, the departments concerned are
not related directly to any particular class of business, but form a support function for the
provider. In this case, it is necessary to find a sensible apportionment of the expenses
across direct business activities. For some costs a ‘charging out’ basis could be used –
computer time and related staff resources could be charged to the direct function
departments based on actual use. Premises costs can be allocated by floor space taken up
by a department. For other costs such as statutory fees or senior management costs a more
arbitrary basis may be required. These costs could simply be added at the end of the
analysis as a percentage loading to all the other attributed costs.

As well as apportioning expenses to a line of business, costs need to be apportioned by

function, so that they can be allowed for in determining product pricing or the provisions
for future liabilities. For most types of business the high level division is into the costs of:

 securing new business

 maintaining existing business (renewal and investment)
 terminating business (including claims)

Depending on the purpose of the expense analysis, these items may be sub-divided. For
example new business costs might be split into marketing; sales and commissions;
processing and policy issue; and underwriting.

An important element of any product pricing process will be the inclusion of loadings for
expenses. These are required to ensure that sufficient premiums are charged to cover not
only the expected claim costs, but also the costs of expenses related to administration and
claims handling for the business written on these rates, and provide a contribution to the
general fixed costs of the provider.

The loading for expenses could be allowed for as follows:

 as a fixed amount per contract

 as a percentage of the premium charged
 as a percentage of the sum insured/assured
 a combination of the above

END

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2016 Developing the cost and the price Subject CA1

UNIT 15 — DEVELOPING THE COST AND THE PRICE

Syllabus objectives

7.4.1 Discuss how to determine the cost of providing benefits on contingent events.

7.4.2 Discuss the factors to take into account when determining the appropriate level
and incidence of contributions to provide benefits on contingent events.

7.4.3 Discuss the factors to take into account when determining the price or the
contributions to charge for benefits on contingent events.

7.4.4 Discuss the influence of provisioning or reserving requirements on pricing or

setting financing strategies.

1 The cost of providing benefits

Once a model has been developed to determine the theoretical value of benefits to be
provided on future financial events further work needs to be undertaken to translate this
value into a premium or cost to the customer.

The “cost” of benefits can be described as the amount that should theoretically be charged
for them.

The “price” of benefits can be described as the amount that can be charged under a
particular set of market conditions and may be more or less than the “cost”.

The premium or contribution could be calculated such that:

Value of future premium(s) = Value of benefit + value of expenses + contribution to profit

The contribution to profit might be negative according to market conditions.

However, other factors will need to be taken into account for example:

 taxation
 commission — although this might be included as an expense
 the cost of any capital supporting the product
 margins for contingencies
 the cost of any options and guarantees
 the basis that will be used to set future provisions for the liabilities — as this may be
different from the basis used to determine the cost
 the use of experience rating to adjust future premiums
 investment income
 reinsurance costs

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Subject CA1 Developing the cost and the price 2016

Profit testing models can then be used to estimate the results of providing the product
under different scenarios. The basic principles of the models used are discussed in Unit
12. The scenarios can be tested using either stochastic simulation, or a set of deterministic
scenarios, depending on the relative risk exposure and the cost/benefit analysis of the
proposed modelling approach.

Finally there will need to be some market testing to assess that the product is actually one
customers want and can afford. There are normally two ways of viewing a product price:

 Factor a profit criterion into the pricing process, and thus calculate the resultant
premium. Test whether the premium is acceptable in the market.

 Input the desired premium into the pricing model and calculate the resultant profit.
Test whether this is acceptable to the company.

2 Determining the appropriate level and incidence of

contributions
It is not always necessary for funds to be established to provide benefits on future
contingent events. For example:

 A company may choose to self-insure its motor damage risks. It will just pay for
repairs as they arise.

 A government may choose to pay state benefits to the retired out of current taxation
revenue from working individuals and companies.

 Where risks are insured, the period of cover may be short, and each contribution
might just purchase cover until the next contribution is due.

Where significant sums are involved for individuals and companies, it is usual for monies
to be set aside before the full benefit becomes due. This mitigates the risks of the direct
payment approaches, and there is a range of options that could be followed:

 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, i.e. a lump sum in advance, or single premium

 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, i.e. terminal funding

 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, i.e. regular contributions

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 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 (e.g. bankruptcy
or change in control), i.e. just-in-time funding. Or if the anticipated risk event does
not happen then terminal funding or a pay-as-you-go approach could be used.

 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

In some situations, for example to encourage retirement saving, governments may use the
tax system to make some of these approaches more advantageous than others.

Different approaches to the incidence of funding will also affect the allocation of risks
between the individual or company exposed to the contingent event, and the provider of a
financial product to mitigate those risks. Consequently this will influence the level of
contributions required. For example in a territory with a well developed fixed interest
investment market, a single premium at inception can be invested at a known yield to
provide appropriately timed cash flows. If a stream of regular premiums is paid, the
provider will have to include a margin for the risk of changes in future investment rates.
This will increase the overall cost.

3 Determining the price or contributions to charge for

benefits
Providers selling financial products, schemes and contracts in the market may charge
premiums or require contributions that differ from the actual cost, for example:

The provider’s distribution system for the product may enable it to sell above the market
price or to take advantage of economies of scale and reduce the premiums charged.

A cheaper price might also be as a result of the provider taking a lower contribution to
expense overheads and profit.

There may only be a limited number of providers in the market and so higher premiums
can be charged. Alternatively if there are many providers in the market and customers can
choose between them, premiums will fall. In general insurance this is known as the
underwriting cycle.

A cheap product may attract customers to other, more profitable products of the company.
The company may expect greater profits across its whole product range.

The provider will also need to decide whether it is prepared to offer the business on a
single premium or a regular premium basis or both. The provider may charge a higher
premium for regular premium policies, in order to encourage policyholders to pay the
whole premium up front.

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Subject CA1 Developing the cost and the price 2016

For a benefit scheme such as a final salary pension scheme the calculated contribution rate
based on the cost of the benefits accruing is often adjusted to determine the actual
contribution rate in any year.

The actual contribution rate may be different from the calculated contribution rate for the
following reasons:

 The assets held are higher or lower in value than the accrued liabilities and there is
thus a surplus or shortfall. This will normally be used to adjust the calculated cost for
a number of future years.

 The sponsor may want to change the pace of funding of the scheme by paying a higher
or lower contribution in any year. This might be due to the sponsor’s financial
circumstances and be unrelated to the scheme’s financial position. The limits within
which contributions can be paid may in some circumstances be restricted by
legislation.

Example

A general insurance company writes private motor insurance business.

List the reasons why it might undertake an investigation of premium rates for this
business.

Solution

An investigation of premium rates for this business may be undertaken to:

 ascertain the overall profitability of the current premium rates

 ascertain the overall profitability of proposed new premium rates

 analyse segment level profitability of the current premium rates

 analyse segment level profitability of proposed new premium rates

 investigate loss ratios on current premium rates that are not in line with expectations

 compare current rates with those of competitors

 review the suitability of the current rating structure in light of the current risk
environment, allowing for changes in the political areas, legislation, traffic, new
technology etc.

 assess the effect of lapse rates

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 assess the impact of cover changes, new perils included, old perils excluded,
changes in excess, etc.

 assess the extent of any cross-subsidies

4 The influence of provisioning or reserving requirements

Traditionally financial product providers calculated the cost of financial products using a
formula similar to that in Section 1 above. Risk margins were included in the various
assumptions. The resultant costs of the financial product made no allowance for the cost
of establishing provisions an a prudent supervisory basis, or of any explicit solvency
capital that needs to be held.

This solvency capital, made up of both explicit margins and the prudential margins in the
reserving basis, cannot be used by the product provider for any other purpose. Thus it is
important to allow for the opportunity cost of the capital not being available for use by the
organisation on other ventures. The cost of establishing provisions and solvency capital
should be included as negative cash flow during the term of the contract, and the
prudential margins in the provision and the explicit solvency capital should be released as
a positive cash flow when the contract terminates.

Example

A life insurance company writes a significant volume of term assurance business. New
business volumes have fallen by 30% over the past three months. Analysis of the market
indicates that a 20% reduction in premium rates is required to regain lost business and
achieve the target of a 10% increase in the volume of new business.

(i) State possible reasons for the fall in new business.

(ii) Describe how the impact on profitability of this reduction in premium rates would
be determined.

(iii) Discuss the factors that would be considered before a rate reduction was
implemented.

Solution

(i) The fall in new business may be:

 As a consequence of competitors’ actions, for example the introduction of new

product features, price cuts or commission rises.

 Simply due to the external factors causing a fall in market volumes, for example,
the economic situation or changes to the tax or regulatory environment.

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Subject CA1 Developing the cost and the price 2016

 Due to internal problems, for example the company may have suffered
reputational issues, for example from poor service standards or adverse press
comment.

(ii) In order to calculate the impact of the change in rates a series of profit tests would
be performed using the revised premium rates.

It is important that up to date assumptions are used for all elements of the basis. In
particular it is likely that mortality rates may have improved since the rates were set
and future improvements may be able to be taken into account. Per policy expense
assumptions may change if expected volumes result in a different allocation of fixed
costs. Experience investigations are needed for mortality, expenses and persistency.

A model of the expected new business would be constructed to assess overall

profitability. It will be particularly important to assess the effects of the expected
growth in business not materialising. If rates are reduced and no additional business
is written, even greater losses will be incurred.

Profitability would be calculated on various measures: internal rate of return;

discounted payback period; and net present value. Each gives a different insight into
profitability.

(iii) If the new rates are still profitable, they can be implemented. If they are not
profitable, a limited price cut may be possible, or the product could be sold as a loss
leader.

Price cuts for particular ages and terms could give rise to discontinuities in rates and
marketing difficulties.

If certain rates are unprofitable there is the possibility of changes in business mix
leading to anti-selection or policyholders discontinuing their policies and taking out
new ones.

It will be necessary to consider the profitability of the total portfolio. Volumes of

new business are expected to rise but the profit per policy will be reduced.

The reactions of competitors and the possibility of long-term problems with price
wars need to be considered.

As do the capital requirements of writing increased volumes that will increase new
business strain. Reinsurance can reduce the impact of this, but will probably reduce
profitability further as the reinsurer will wish to make a profit too.

Alternatives to cutting rates to restore volumes should be considered. For example,

adding other features like conversion/extension options or rider benefits, or offering
additional sales support to insurance intermediaries.

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It will be necessary to implement control processes to monitor new business

volumes quickly, and ensure that action is taken if they do not increase.

END

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2016 Investment Management Subject CA1

UNIT 16 — INVESTMENT MANAGEMENT

Syllabus objectives

7.5.1 Discuss the principles and objectives of investment management and analyse the
investment needs of an investor, taking into account liabilities, liquidity
requirements and the risk appetite of the investor.

7.5.2 Discuss the different methods for the valuation of individual investments and
demonstrate an understanding of their appropriateness in different situations.

7.5.3 Discuss the different methods for the valuation of portfolios of investments and
demonstrate an understanding of their appropriateness in different situations.

7.5.4 Show how actuarial techniques and asset/liability modelling may be used to
develop an appropriate investment strategy.

7.5.5 Discuss methods of quantifying the risk of investing in different classes and sub-
classes of investment.

7.5.6 Describe the use of a risk budget for controlling risks in a portfolio.

1 Principles and objectives of investment management

1.1 Institutional investment objectives
Investment objectives should be clearly stated, and quantified where possible. Since it is
generally often necessary and appropriate to invest in risky assets the objectives must be
framed in such a way as to encompass the allowable degree of risk as well as the required
total return and cash flow timing.

The objectives can be described in various ways. One is to meet the liabilities as they fall
due. Alternatively, the objective could be to control the incidence of future obligations on
a third party (for example, the employer’s contribution rate to a pension scheme). The
concept of meeting the liabilities becomes more complex if liabilities continue to accrue
(for example a life fund which is still writing business or a pension scheme open to future
accrual). For a continuing entity meeting the liabilities as they fall due and proving that
there are sufficient resources to do so are separate objectives, both of which have to be
met. There may also be a need to demonstrate that there are sufficient assets available
should the provision of future benefits be discontinued.

1.1.1 Risk

The word risk has many different meanings in investment management. It can be used to
describe the probability of a particular investment failing completely. More frequently it
is used to signify the expected variability of the return from an investment.

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Subject CA1 Investment management 2016

From a business point of view neither definition is entirely satisfactory. The probability of
complete ruin from a well diversified portfolio of securities is small. The short term
variability in the market value of a portfolio is also of little relevance to many institutions,
since it takes no account of changes in the liabilities as the asset portfolio changes.

The most practical definition of risk is the probability of failing to achieve the investor’s
objective. However, it must be recognised that investors are subject to many different
risks. For many institutions the risk of underperforming compared with their competitors
is one of the most pressing day-to-day risks.

The risk appetite of an institution will depend on the nature of the institution and on the
constraints of its governing body and documentation, together with legal or statutory
controls.

1.1.2 Factors influencing investment strategy

The principal aim of an investing institution is to meet its liabilities as they fall due. The
overriding need is to minimise risk.

The main factors that will influence a long term investment strategy are:

 The nature of the existing liabilities — are they fixed in monetary terms, real or
varying in some other way?

 The currency of the existing liabilities.

 The term of the existing liabilities.

 The level of uncertainty of the existing liabilities — both in amount and timing.

 Tax — both the tax treatment of different investments and the tax position of the
investor need to be considered.

 Statutory, legal or voluntary restrictions on how the fund may invest.

 The size of the assets, both in relation to the liabilities and in absolute terms.

 The expected long term return from various asset classes.

 Statutory valuation and solvency requirements.

 Future accrual of liabilities.

 The existing asset portfolio.

 The strategy followed by other funds.

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 The institution’s risk appetite.

 The institution’s objectives.

 The need for diversification.

Institutions need to be aware of the long term investment strategy which will most closely
match their liabilities by nature, currency and term. Even if they do not, or cannot adopt
such a strategy, other strategies should be evaluated against this benchmark.

The uncertainty of the liability outgo, both in timing and amount, needs to be considered.
Institutions with uncertain liabilities will need to hold marketable assets.

Institutions may also need a strategy that will continue to satisfy the requirements of
regulators.

Subject to the above considerations, an institutional investor will seek to maximise the
investment return. This may be for competitive reasons, in order to continue to attract new
business, to maximise shareholders’ returns, or to minimise the cost of providing for the
liabilities.

Investors’ preferences for income or capital growth from their investments are governed
by two main factors: tax and cash flow requirements. If an institution is subject to
different taxation bases on income and capital gains it will prefer to receive as much of its
total return as possible in the lower taxed form.

Investors who have low present cash flow requirements may prefer low income yielding
investments to avoid the expense and uncertainty of reinvesting income. Conversely
investors who need current income may prefer high income yielding investments to avoid
the expense and uncertainty of realising assets.

For some long term institutional investors, fluctuations in asset market values are not of
much concern, particularly if the strategy is to hold assets to maturity. However, they may
be important for institutions that are required to demonstrate solvency on a regular market
value basis and have a low level of free assets. Fluctuating asset values are also, in
general, disliked by retail customers of some institutions.

1.1.3 Tactical asset allocation

An attempt to maximise returns may involve tactical asset allocation, which is a departure
from the benchmark position and hence conflicts with the minimisation of risk. The size
of the assets relative to the liabilities will determine the risk involved in such an action.

Factors to be considered before making a tactical asset switch are:

 the expected extra returns to be made relative to the additional risk (if any)
 constraints on the changes that can be made to the portfolio
 the expenses of making the switch

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 the problems of switching a large portfolio of assets

1.1.4 Selecting individual investments

When selecting individual investments, the important factor for an institution is the effect
that the investment will have on the performance of the total portfolio. Thus not only are
after tax expected return and variability of the return important, but so is the covariance of
that return with the rest of the portfolio. Investments that have a low covariance with the
rest of the portfolio represent diversification and will reduce overall risk. For any
investment type, there are many issues to be considered.

1.2 Individuals’ investment strategies

The main factors to be considered by an individual do not differ greatly from those that
should be considered by an institution. However the balance between the factors and the
details do differ.

1.2.1 Nature of assets and liabilities

An individual’s assets consist of current wealth and future income. Liabilities consist of
future spending, including any debt repayments. Both the term and nature of future
spending will need to be considered as well as the expected level.

The sophistication of the planning process used by individuals will vary greatly, but most
will take some account of the pattern of their expected future income and major likely
expenditure, such as a house purchase, in making their plans.

Most of an individual’s liabilities will be real in nature, although the relevant index
measure may not be any particular inflation index. Occupational income can be
considered as a real income stream, but pensioners may be on a largely fixed income.

Because liabilities will generally be real, assets for long term investment should usually be
real although monetary assets may be chosen for short term investments, diversification,
because the individual is risk averse, or because they appear good value.

Most investors will have liabilities and hence assets in their domestic currency, although
there may be special reasons for holding investments denominated in other currencies.

1.2.2 Investment freedom

Individuals may be constrained in their choice of investments by the size of their liabilities
relative to their assets. They will often not be in a position to accept very much risk.
Attitude to risk is partly a personal matter as well as being dependent on an investor’s
financial position.

Risk can be reduced by diversifying assets both between and within asset classes.

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A major constraint is uncertainty. Individuals may lose much of their income for a variety
of reasons, such as redundancy or ill health. Similarly unexpected expenditure
requirements can easily occur. Therefore it will be desirable to keep some assets in a
reasonably liquid form. Insurance can also be used to mitigate the effect of some types of
uncertainty.

1.2.3 Expected return

In addition to the considerations of matching liabilities and allowing for uncertainty,

individuals will wish to maximise their expected return. This means selecting assets that
are good value after allowing for:

 the expenses of dealing in the asset

 the individual’s tax situation

Differences in taxation can mean that an investment, which is good value to one person,
can be unsuitable for another. Some investments are particularly efficient for taxpayers.
This is usually because the government specifically desires to encourage investment of a
particular form. Sometimes investment products are launched that exploit an unintentional
tax loophole. These are usually aimed at the wealthier investor and can have a very short
lifespan before the loophole is closed.

1.2.4 Practical considerations

Individuals usually face practical constraints not suffered by institutions. These can
include:

 not enough assets for direct investment in some asset classes

 high relative expenses when investing small amounts
 lack of information and/or expertise

1.2.5 Cash flow requirements

Many individual investors, particularly the retired, rely on the income from their
investments for their basic lifestyle needs. In this situation it is necessary to find a strategy
which will provide a high enough current income while allowing for sufficient growth of
capital and income to maintain the level of income in real terms.

Income can be provided by regular redemptions or periodically selling part of a low

income yielding portfolio.

A different situation is faced by investors who are investing for the long term, and don’t
require a current income from their investments, possibly because they are still working.
They will be concerned with reinvestment of income and maturity proceeds but, in
general, are freer to concentrate on maximising total return.

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1.2.6 Variability of market value

Individuals investing for the long term may not be concerned about short term variations
in the market value of their investments. However, in practice, most people dislike
excessive volatility, particularly if their liabilities are uncertain or are short term.

A suitable strategy is often to switch to less volatile assets as the time at which the
investments need to be realised draws near.

1.3 Active and passive investment management

In managing investments, whether directly or through a specialist manager, there are two
distinct approaches that can be adopted — active management and passive management.

Passive management is the holding of assets that closely reflect those underlying a certain
index or specific benchmark. The manager therefore has little freedom to choose
investments.

Active management is where the manager has few restrictions on the choice of
investments, perhaps just a broad benchmark of asset classes. This enables the manager to
make judgements as to the future performance of individual investments, both in the long
term and the short term.

Active management is generally expected to produce greater returns due to the freedom to
apply judgement. However, this is likely to be offset by the extra costs involved in more
regular transactions, particularly when attempting to make short term gains. Active
management also carries the risk that the manager’s judgement is wrong and so the returns
are lower. Passive investment is not entirely risk free as the index may perform badly or
there may be tracking errors.

2 Valuation of investments
2.1 Valuation methods for investments
If the asset is traded on an open market and published prices are freely available then
market value is a reference point for all valuations. If there is no market price then other
methods of determining the best proxy for market value should be used. Having first
established either the market value or the proxy market value on the valuation date, the
actuary may then decide to employ an asset valuation method appropriate to the purpose of
the valuation. If the purpose is an overall valuation of assets and liabilities for a financial
structure, it is necessary to adopt a method that values assets and liabilities on a consistent
basis.

Some of the methods used are:

 Book value: historic book value is the price originally paid for the asset and is often
used for fixed assets in published accounts. Written up or written down book value is

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historic book value adjusted periodically for movements in value. Neither of these
methods lends itself to the use of a consistent liability valuation (because the
appropriate discount rate for the liability valuation cannot be determined).

 Market value: the market value of an asset varies constantly and can only be known
with certainty at the date a transaction in the asset takes place. Even in an open market
more than one figure may be quoted at any time. However, for many traded securities
it is an objective and easily obtained figure and is a starting point for asset valuation.

 Smoothed market value: where market values are available they can be smoothed (for
example by taking some form of average over a specified period) to remove daily
fluctuations. This method does not lend itself to consistent liability valuations (again
because the appropriate discount rate for the liability valuation is indeterminate and
requires judgement. In practice the assessment becomes a view as to whether the asset
is cheap or dear in relation to its smoothed market value).

 Fair value: in accounting terms fair value is the amount for which an asset could be
exchanged or a liability settled between knowledgeable, willing parties at arms length.
This definition does not specify how such a value is calculated.

 Discounted cash flow: this method involves discounting the expected future cashflows
from an investment. It has the advantage of being easily made consistent with the
basis used to value an investor’s liabilities. However, it relies on the assessment of a
suitable discount rate, which is straightforward where the assets are, for example,
high-quality fixed interest stocks but is less so otherwise.

 Stochastic models: these are an extension of the discounted cash flow method in which
the future cash flows, interest rates or both are treated as random variables. The result
of a stochastic valuation is a distribution of values from which the expected value and
other statistics can be determined. This method is particularly appropriate in
complicated cases where future cash flows are dependent on the exercise of embedded
options, for example the option to wind up in adverse financial circumstances.

 Arbitrage value: arbitrage value is a means of obtaining a proxy market value and is
calculated by replicating the investment with a combination of other investments and
applying the condition that in an efficient market the values must be equal. The
technique is often used in the valuation of derivatives.

2.2 Market values compared with calculated values

Modern finance theory suggests that where an efficient market exists, the resulting market
value will reflect all publicly available information and is the underlying “economic
value” of the asset at a given point in time. Market values can be subject to considerable
fluctuation and it is sometimes argued that the use of market value depends on the vagaries
of the market and obscures the underlying or intrinsic value of the asset. The
counterargument is that using another valuation method in an attempt to identify the
intrinsic worth of an asset involves an investment call as to the direction the market in that
asset (or class of asset) will move.

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A market method or a calculated method can be used as a filter for selecting shares for sale
or purchase for further consideration. In practice other factors would be taken into account
before making buying or selling decisions.

If a value other than market value is used then it is important to make the implications of
this clear to the client. This is particularly true when short term solvency is being
considered.

2.3 Bond valuations

Government or similar high quality bonds can be valued by discounting cash flows at rates
consistent with the market spot rate yield curve. Other bonds, such as corporate bonds,
can be valued similarly but adjusting the yield to allow for lower security and
marketability.

Many bonds have option features (e.g. callable and puttable bonds). Such bonds should
theoretically be valued using option pricing techniques, although this is not always done in
practice.

2.4 Equity valuations

Typically the valuation of a portfolio of ordinary shares would be carried out by assuming
the shares were swapped for a holding in an index.

2.4.1 Dividend discount model

The dividend discount model derives the value of a share as the discounted value of the
estimated future dividend stream.

The general model can be expressed as:


V   Dt v(t )
t 1

where:

V is the value of the share

Dt is the gross amount of the tth dividend payment

v(t) is the discount factor applied between time 0 and the time of the tth dividend
payment

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A simplified equation can be obtained by assuming that dividends are payable annually,
with the next payment in one year’s time; that dividends grow at a constant rate, g,
per annum; and that the required rate of return, i, is independent of the time at which
payments are received. With these assumptions the equation becomes:

D0 (1 + g )
V=
(i  g )

where:

D0 is the most recent dividend received.

In order to calculate a value it is necessary to decide on an appropriate required rate of

return. This would often be calculated as the yield on long term government bonds plus an
appropriate addition for the riskiness of the income stream. Investors with real liabilities
might start from an index-linked government bond yield and estimate the real, rather than
nominal, rate of dividend growth.

The equations given above ignore tax. Tax-paying investors should use the net dividends
received and a suitable after-tax rate of return.

In practice it might be felt that constant dividend growth is not a realistic assumption. An
alternative approach would be to use dividends based on profit forecasts for the first few
years, then apply a short term rate of growth for a period until the growth rate settled down
to a long term average.

2.4.2 Value added measures

Shareholder value is an attempt to get at the intrinsic or underlying value of an investment

rather than its accounting value. Stern Stewart, a US consulting firm, has trademarked the
concept of EVA, economic value added. EVA looks at one year’s results and deducts the
cost of servicing the capital that supports those results. EVA acts as a bridge between
quoted share value and accounting values to give a framework for executive compensation
schemes designed to produce results that increase shareholder value.

2.4.3 Other equity valuation methods

Where companies are not making profits and a net asset valuation is not appropriate, other
methods have to be employed if a calculated valuation is required of an individual share.
These methods often involve determining a relevant and measurable key factor for the
company’s business. The relationship between this factor and the market price of other
quoted companies is then used as a basis for valuation. The factor used will depend on the
particular business of the company.

2.5 Property valuation

Property can be valued using an explicit discounted cash flow approach. The cash flows
valued should be net of all outgoings and should make explicit allowances for the expected

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rate of rental increases. Should a property be let at a rent less than the open market rental
value, then the passing (i.e. current) rent is valued to the next rent review, and thereafter
the open market rental value is valued. Should a property be let at a rent greater than the
open market rental value (i.e. the property is over rented), then due allowance needs to be
made for this. It will be necessary to know whether the terms of the lease allow for
downward rent reviews.

The discount rate used should depend on the riskiness of the investment and could be
based on the yield on a bond of suitable term, plus margins for factors such as risk and
lack of marketability.

2.6 Valuation of options and futures

Options and futures are usually valued using techniques based on the principle of “no
arbitrage”. The value taken is the cost of closing out the contract.

2.7 Valuation of swaps

Swaps can be valued by discounting the two component cash flows. At inception the
value (at market rates of interest) of a swap to both parties will be zero, ignoring the
market maker’s profit and expenses. As market interest rates change the value of the two
cash flows will alter, leading to a positive net value for one party and a negative net value
to the other. Even if rates don’t differ from what was expected, the value of a swap is
likely to be positive for parts of its term and negative for others.

An alternative way of viewing a swap contract is as a series of forward agreements. If

each of these forward agreements can be valued, then so can the swap.

3 Methods for the valuation of portfolios of investments

3.1 Analysis of expected returns from different assets
The relative value of different asset classes can be analysed by considering the relationship
between the expected and required returns. The expected return and the required return
can each be broken into component parts:

1. The total return comes from income and capital gain. Therefore:

expected return = initial income yield + expected capital growth

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2. The nominal return an investor requires from an asset is the sum of three components,
based on a return in excess of inflation and a risk premium. The risk premium on a
particular asset class will depend on the characteristics of the asset and investors’
preferences, which will be largely driven by their liabilities. The risk premium in the
equation below may cover any adverse feature of one investment relative to another
for which investors require compensation:

required nominal return = required risk free real yield + expected inflation
+ risk premium

Cheapness or dearness can be established if it appears that the expected return is different
from the required return. If there is a market in index-linked government bonds the
required risk free real yield can normally be taken as the real yield on these bonds.

In the discussion below a number of simplifying assumptions are made:

 that all investors want a real rate of return

 all investors have the same time horizon for investment decisions
 tax differences between investors can be ignored
 reinvestment can occur at a rate equal to the expected total return on the asset

In reality all these assumptions are questionable.

For each of the main asset categories, the expected return from a portfolio of assets will be
equated with the required return for that asset category. The equations derived are valid if
the assets considered are fair value relative to each other.

3.1.1 Conventional government bonds

The expected return is taken to be the gross redemption yield (GRY). Equating the
expected return with the required return:

GRY = required risk free real yield + expected inflation + inflation risk premium

3.1.2 Corporate loan stocks

A similar development is possible for corporate loan stocks

GRY = required risk free real yield + expected inflation + bond risk premium

Investors require a higher yield than from conventional government bonds to compensate
for the greater risk of default and the lower marketability. Therefore the bond risk
premium has three main components:

 inflation risk premium

 default premium
 marketability/liquidity premium

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3.1.3 Equities

The expected return from equities can be expressed as d + g where:

 d is the income stream, i.e. the dividend yield

 g is the expected capital gain, i.e. the expected annual growth in dividends

Therefore:

d + g = required risk free real yield + expected inflation + equity risk premium

The equity risk premium is needed to compensate the investor for:

 possible default
 marketability
 high volatility of share prices and dividend income

3.1.4 Property

The form of the equation for property investment is very similar to the equation for
equities:

rental yield + expected growth in rents

= required risk free real yield + expected inflation + property risk premium

3.1.5 Yield gap and reverse yield gap

The traditional basis for comparing government bonds and equities is the yield gap.

The yield gap is:

equity gross dividend yield  gross redemption yield on a long dated benchmark bond

Prior to the late-1950s, the yield gap was generally positive. Since then, the yield gap has
usually been negative. Hence the “reverse” yield gap emerged. The reverse yield gap is
the gross redemption yield less the gross dividend yield.

The reverse yield gap can be split into its component parts:

GRY  d = inflation risk premium (IRP)  equity risk premium (ERP) + g

Where d and g are defined as in section 3.1.3 above.

Because the expected growth in dividends can be split into two components (expected
inflation + expected real dividend growth), the reverse yield gap can be expressed as four
components:

IRP  ERP + expected inflation + expected real dividend growth

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3.1.6 Property versus other sectors

Traditionally, rental yields on property have been compared with the dividend yields from
equities. The reasoning behind this comparison is that both rents and dividends should
increase in the long term.

The gap between rental yields and dividend yields should be made up of the following
components:

property risk premium  equity risk premium + expected dividend growth

expected rental growth

If the expectations for property rental growth are not generally high it is more appropriate
to compare the rental yields on property with the gross redemption yields from
conventional bonds.

rental yield  GRY = property risk premium  inflation risk premium

 expected rental growth

To justify property rental yields being above government bond yields, then one or more of
the following must hold:

 low expected future inflation

 very low prospects for real rental growth
 justifiably high risk premium for properties

If these conditions do not hold, and property rental yields are above government bond
yields, property appears cheap relative to conventional government bonds.

3.1.7 Currency factors

For an investor wanting to maximise returns in his or her domestic currency, it is also
necessary to allow for the expected changes in the currencies over the period of the
investment.

An overseas market would be considered cheap if:

expected return in local currency + expected depreciation of home currency

> expected return in home currency

The investor should consider investing overseas if the margin of the left-hand side over the
right-hand side exceeds the risk margin the investor requires for overseas investment.

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3.1.8 Other methods

There are a number of other tests of relative value that investment analysts also use from
time to time. These include:

Yield “norms”: For some of the asset categories, there might be a normal level or range.
Care must be taken that there haven’t been fundamental changes that have led to a shift of
the “normal” range.

Index levels and price charts: technical analysis is sometimes used to compare the value of
asset groupings as well as individual assets.
Yield ratios: the yield ratio is sometimes used when assessing the relative price of equities
and bonds. However, if the previous analysis is accepted it will be seen that the ratio has
to be used with care as an indicator of relative value.

3.2 Relationship between the assets and liabilities

The method and basis for any actuarial valuation will depend on the purpose of the
valuation and the type of liability. For certain supervisory valuations the actuarial method
and basis will be set out in regulations. In other cases, within the limits of professional
guidance, the actuary has freedom to choose the method and basis he or she feels is
appropriate. It is important that the valuations of assets and liabilities are consistent. This
means that if assets are valued at market value then liabilities should be valued at
appropriate market based discount rates. Alternatively both assets and liabilities could be
valued using the same interest rate, which would normally represent the long term
expected return on the assets held to back the liabilities.

Any market value implies an expected rate of return linked to the risk of the asset.
Therefore it can be argued that the use of a single discount rate to value all assets and
liabilities is inappropriate and different discount rates should be used depending on the
risks within the assets and liabilities to be valued and possibly other factors such as
marketability and term.

Since few types of liabilities are marketable, the discount rate has to be based on that
applied to those assets that most closely match the liabilities. Whether it is useful or not in
practice to adopt such an approach depends on the purpose of the valuation.

3.3 Allowing for the variability of asset prices

There are two sorts of variability to consider.

Firstly, an asset valuation result may be very volatile over a short period of time due to
market movements (e.g. if market value is used).

Secondly, an asset valuation result may be changed due to a change in the investment
portfolio (for example, a major switch from government bonds to equities may
significantly alter a value of assets based on discounted income flows).

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These two aspects might be described as:

 stability over time

 influence of short term investment decisions over the value of assets

Volatility of asset value is often stated as the main problem with a market value of assets.
However, it can be argued that stability itself is not a desirable feature of asset valuation,
and that consistency overrides the question of stability. Volatility of asset value is not a
problem in itself — a volatile asset value may correctly reflect the underlying reality.
However, in the context of the ongoing valuation of a long term fund, comparing volatile
asset values with a value of liabilities calculated using a stable interest rate is potentially
misleading. In other words, the problem with a market value of assets is not the volatility
of asset valuation as such, but inconsistency of asset and liability valuation bases.

In practice, stability is sometimes considered a desirable feature of asset valuation. An

unstable value of assets may make results harder to communicate and interpret. Also, it
may not in practice be easy to ensure that the liability valuation result really is consistent
with an unstable value of assets.

One possible solution is to modify the method of valuing assets to make the value more
stable and hence more consistent with a value of liabilities calculated using stable
assumptions. Some sort of smoothed market value is therefore sometimes seen as the
solution to the problem with market values. A more common method is the discounted
cash flow method, using a long term interest rate assumption which is held relatively
constant.

4 Developing an appropriate investment strategy

4.1 Matching cash flows
In its purest form matching of assets and liabilities involves structuring the flow of income
and maturity proceeds from the assets so that they coincide precisely with the net outgo
from the liabilities under all circumstances. This requires the sensitivity of the timing and
amount of both the asset proceeds and the net liability outgo to be known with certainty
and to be identical with respect to all factors.

Given infinite resources it will always be possible to meet the outgoings by buying
excessive amounts of securities. In practice, therefore, the matching portfolio is the
portfolio which costs the least and which still provides the required certainty of meeting
the liabilities.

Unless risk free zero coupon bonds can be used it is rarely possible to achieve pure
matching, although a close approximation to a perfect match may be possible for certain
life insurance products, such as guaranteed income bonds. Moreover, the relative price of
the bonds chosen for the matching may be such as to deter all but the most dogmatic
institutions. A further problem is that for some funds the length and size of the liabilities

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may be such that complete matching is unattainable because suitable assets are not
available.

4.2 Actuarial techniques for determining investment strategy

An investor’s objectives will normally be stated with reference to both assets and
liabilities. In setting an investment strategy to control the risk of failing to meet the
objectives, a method that takes into account the variation in the assets simultaneously with
the variation in the liabilities is required. This can be done by constructing an appropriate
model to project the asset proceeds and liability outgo into the future.

The outcome of a particular investment strategy is examined with the model and compared
with the investment objectives. The investment strategy is adjusted in the light of the
results obtained and the process repeated until the optimum strategy is reached.

Modelling can either be deterministic or stochastic. An advantage of stochastic modelling

is that it encourages investors to formulate explicit objectives. The objectives should
include a quantifiable and measurable performance target, defined performance horizons
and quantified confidence levels for achieving the target. For a financial institution the
objectives might be specified in terms of the results of a valuation carried out at a specified
time in the future. In practice there is likely to be feedback between the model output and
the setting of the objectives.

The success of the strategy is monitored by means of regular valuations. The valuation
results will be compared with the projections from the modelling process and adjustments
made to the strategy to control the level of risk accepted by the strategy, if necessary.

4.3 Other techniques for determining investment strategy

Other techniques for establishing a benchmark strategy include:

 performing a mean variance optimisation without reference to the liabilities

 basing asset allocations on market capitalisations
 shadowing the strategies of other comparable institutional investors

5 Measuring risk
Until fairly recently, most attention has been devoted to measuring and managing active
risk — that is the risks from following an active investment strategy.

The most usual backwards risk measure adopted is the retrospective or backwards-looking
tracking error — the annualised standard deviation of the difference between portfolio
return and benchmark return, based on observed relative performance.

The equivalent prospective measure is the forward-looking tracking error — an estimate of

the standard deviation of returns (relative to the benchmark) that the portfolio might

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experience in the future if its current structure were to remain unaltered. This measure is
derived by quantitative modelling techniques.

6 Risk budgeting
The term risk budgeting refers to the process of establishing how much risk should be
taken and where it is most efficient to take the risk (in order to maximise return). The
process for the organisation as a whole is described in Unit 3.

With regard to investment risks, the risk budgeting process has two parts:

 deciding how to allocate the maximum permitted overall risk between total fund active
risk and strategic risk

 allocating the total fund active risk budget across the component portfolios

The key focus when setting the strategic asset allocation is the risk tolerance of the
stakeholders in the fund. This is the systematic risk they are prepared to take on in the
attempt to enhance long-term returns. The key question on active risk is whether it is
believed that active management generates positive excess returns.

Risk budgeting is, therefore, an investment style where asset allocations are based on an
asset’s risk contribution to the portfolio as well as on the asset’s expected return.

A risk budgeting strategy can free the manager to look for alternative investments that
might increase the expected return on the portfolio. Because the constraint is that the total
risk of the portfolio must stay at or below a targeted level, increased attention is paid to
low correlation investments. Allocations to such investments can reduce the total risk of
the portfolio through diversification.

END

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UNIT 17 — PROVISIONING
Syllabus objectives

7.6.1 Discuss the different reasons for the valuation of the benefits from financial and
other products, schemes, contracts and other arrangements and the impact on the
choice of methodology and assumptions.

7.6.2 Discuss how to determine values for provisions in terms of:

 the need for placing values on provisions and the extent to which values
should reflect risk management strategy

 the principles of “fair valuation” of assets and liabilities and other “market
consistent” methods of valuing the liabilities

 the reasons why the assumptions used may differ in different circumstances

 the reasons why the assumptions and methods used to place a value on
guarantees and options may differ from those used for calculating the
accounting provisions needed

 the use of replicating portfolios for valuing liabilities

 the use of stochastic deflators and other stochastic discount methods

 how sensitivity analysis can be used to check the appropriateness of the values

and be able to perform calculations to demonstrate an understanding of the

valuation methods.

7.6.3 Describe different methods of allowing for risk in cashflows.

7.6.4 Describe different methods of allowing for uncertainty in present values of

liabilities.

7.6.5 Discuss the purpose of and uses for equalisation reserves.

7.6.6 Describe the influence of comparisons with market values.

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1 Calculation of provisions
1.1 Why provisions are calculated
Provisions are the calculated amounts that need to be set aside to meet a provider’s future
liabilities. The value of the provisions will depend on the assumptions used to value the
future expected cashflows.

The reasons for calculating the provisions needed by a provider include the following:

 to determine the liabilities to be shown in the provider’s published accounts and

reports

 if separate accounts and reports have to be prepared for the purpose of supervision or
solvency, to determine the liabilities to be shown in those accounts

 to determine the liabilities to be shown in internal management accounts and reports of

the provider

 to value the provider for merger or acquisition

 to determine the excess of assets over liabilities and whether any discretionary benefits
can be awarded

 to set future contributions to a benefit scheme

 to value benefit improvements for a benefits scheme

 to calculate discontinuance/surrender benefits

 to influence investment strategy

 to provide disclosure information for beneficiaries

As well as establishing provisions for each individual contract undertaken by the provider,
or for each member of a benefits scheme, it is frequently necessary to make global
provisions looking at the provider’s liabilities as a whole, if solvency is to be demonstrated
unambiguously.

Unless all the guarantees are in the money, providing for the worst-case scenario for every
contract will mean that unnecessarily large provisions are made. As discussed elsewhere
in the course, guarantees are usually best valued by a stochastic approach, taking the class
of business as a whole.

A provider will be exposed to a range of financial and non-financial risks, which may
merit an additional provision in excess of the sum of the provisions for each contract or
member. For example an additional provision may be necessary to cover the risks from
any mismatching of assets and liabilities.

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1.2 Choice of methodology and assumptions

As the timing and level of benefits, contributions and asset income is not certain, an
actuary can never be certain that a set of assumptions will be correct. Each actuary can
consider information and apply judgement to produce a set of assumptions that they feel to
be their “best estimate” of future experience. This can be considered to be the set of
assumptions that has equal probability of overstating or understating the values.

However, a “best estimate” value is not necessarily the most suitable. The reason why a
value needs to be determined, the needs of the client, or the requirements of any legislative
or regulatory authority, will usually dictate the strength of the basis on which values
should be produced. In some cases the valuation method may also be prescribed.

In many cases, presentation of a range of values, or values for alternative scenarios may be
more useful to the client in making any necessary decisions. For example, before making
a long term financial commitment a retirement benefit scheme’s sponsor may wish to
know the actuary’s “best estimate” of the costs and also the costs assuming a worse
scenario for future experience.

There are occasions when to determine the value of the liabilities it will be appropriate to
take account of the nature of the assets. Examples are:

 When the liabilities are specifically linked to the underlying assets e.g. a unit trust.

 When the covenant of the sponsor has no value e.g. when a pension fund is set up by a
sponsor, but the sponsor makes no commitment to provide funds to make up any
shortfall should the assets held turn out to be insufficient to meet the benefits
promised. In this situation the benefits paid may need to be reduced to reflect the
actual assets available.

 For the supervisory valuation of life insurance contracts, where legislation or

regulation specifies a link between the liability valuation basis and features (usually
the yield) of the backing assets.

1.3 Communication of information to individuals

Individuals may need to make decisions about the level of benefits required, the return that
they gain on contributions and the security of benefit provision.

In order to make decisions relating to their benefit and contribution needs, they will need
to consider values that take account of their individual circumstances. These values may
be most informative if they present a realistic picture. However, the uncertainty of the
values should be communicated so that the individual is aware of the risks of under- and
over-contributing. For example, where an individual is averse to the risk of
underprovision, it may be appropriate to take a cautious approach to the valuation of future
contribution needs.

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2 Relationship with risk management strategy

The provider’s risk management strategy will be an important influence on the level of
provision needed for these additional risks. A detailed and effective risk analysis and
management system, that is regularly monitored and updated, will reduce exposure to
some financial and non-financial risks, and can thus justify holding a lower level of
provision against these risks.

A provider’s risk appetite will also influence the level of provisioning for risks. In
managing the liabilities, there may be a desire to reduce the risk of the provisions set aside
being insufficient to meet the benefits promised. A person or company responsible for the
management of the provision may therefore wish to consider values that are cautious. The
50% probability of underprovision created by using “best estimate” assumptions may be
considered to be too great.

The 50% probability of underprovision created by using “best estimate” assumptions may
also be considered too great by trustees responsible for the funding decisions under a
benefit scheme, particularly if the benefits being valued are discontinuance rights.
However, trustees and beneficiaries must also note the views of the sponsor. It would not
be in the interests of the beneficiaries if a cautious approach to provisioning led to a
sponsor reducing benefits, due to excessive projected cost. In the case of an employer
sponsor, a cautious approach could also lead to other cuts in the business, or perhaps
insolvency. These may also not be in the interests of employee beneficiaries.

3 Fair valuations

In recent years there has been a move to market based or fair value methods of valuation.
These methods seek to place a market value on the liabilities. Two definitions of fair
value are:

 the amount for which an asset could be exchanged or a liability settled between
knowledgeable, willing parties in an arm’s length transaction

 the amount that the enterprise would have to pay a third party to take over the liability

In some cases a fair value of a liability is straightforward. If a contract provides that it can
be terminated at various points in time for particular values, with no discretion on the part
of the product provider, then those values are necessarily the fair values of the liability.
This approach might particularly apply to unit linked investment contracts.

However, as there is no liquid secondary market in many of the liabilities that actuaries are
required to value, the identification of fair values from the market is not practical. As a
result fair values of liabilities need to be estimated using market based assumptions.

One approach to estimating fair values is to consider the liabilities as a series of financial
options, and to use option pricing techniques to assess a value. Details of these techniques
are outside the scope of this course.

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4 Why the assumptions used may differ in different

circumstances
4.1 Decisions by regulators
Regulators may wish to consider values that present a realistic picture of a provider’s
finances. Alternatively they may wish to consider values that intentionally understate (or
perhaps overstate) the financial strength of the provider.

If separate accounts and reports are required as part of the process of supervision of
solvency, the rules governing the preparation of those separate accounts and reports may
or may not be the same as those that apply to other accounts and reports. They may, for
example, be required to be prepared on a going concern basis or on a discontinuance basis.
Reference should be made to the rules and any guidance that may have been issued as to
their interpretation.

The assumptions used may be dictated by legislation or left to actuarial judgement with a
requirement for disclosure of the assumptions used.

4.2 Decisions relating to investments

A decision relating to financing, including any investments held to meet future liabilities
will involve the consideration of realistic and cautious values for a potentially large
number of options. It is likely that a stochastic approach can add significant value in
assessing the risks and values under each possible strategy.

4.3 Decisions by shareholders

Shareholders and potential shareholders make decisions on the basis of information in a
company’s accounts. It is therefore preferable for values to be included in the accounts
that represent an actuary’s “best estimate” of the future experience. The use of
assumptions that are more likely to overstate, or understate the liabilities or assets, may
lead to wrong decisions being made.

The assumptions to be made in determining the liabilities to be shown in a provider’s

published accounts and reports should have regard to the legislation and accounting
principles governing the preparation of those accounts in the territory concerned. Matters
to be considered include:

 whether the accounts and reports are to be prepared on a going concern basis

 whether the accounts and reports are required to show a true and fair view

 whether provisions are required to be assessed as best estimates or on some other

basis, and precisely how the terms used are to be interpreted

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4.4 Liability transfers

It may become necessary to transfer liabilities and assets, from one party to another. In
such cases the values being placed on benefits and assets have a real monetary worth. It is
therefore important that both the transferring and receiving parties view the terms of the
transfer as being fair.

In many cases the need to be fair or the need to agree with another actuary will mean that
the assumptions used will be a “best estimate” of future experience. However, this need
not always be the case.

Where a negotiation is taking place the agreement reached between the two sides may be
influenced by the relative power of the parties for whom the actuaries are acting. For
example, one party may have more desire for the transfer to go ahead than another.

It is also possible that the two sides agree that the transfer amount should not reflect a
“best estimate” of future costs, perhaps because of recognition of a need to hold a margin
to protect the security of the benefits.

4.5 Benefit scheme membership structure

For benefit schemes, the structure of the scheme membership can have an effect on the
assumptions used. For example, a scheme that is closed to new members will have a
membership that will grow older as members retire, leave or die. This will have to be
taken into account in assessing future contributions. Conversely, in an open scheme with a
large active membership, it is likely that leavers will be replaced with new recruits, and
thus that the average age of the active membership will be broadly unchanged. This
assumption may generate a different future contribution rate than for the closed scheme.

5 Valuing guarantees and options

In general when setting the terms for options or guarantees, a cautious approach is taken.
However a cautious valuation basis will not automatically produce cautious terms for an
option or a guarantee. With options there is a risk of selection against the provider. This
can be guarded against in setting eligibility criteria for the option or by setting terms that
favour one option over another.

With guarantees there is a risk that the guarantee will apply and so the costs will be greater
than would otherwise have been the case. The value of financial guarantees will normally
be assessed using a stochastic model. The parameters input to the model should reflect the
purpose for which the results are required. The level of prudence required, or alternatively
the required risk that the provision established will be inadequate will affect the results
from the model.

In placing a value on options when setting provisions, it may be appropriate to assume that
the highest cost option is always exercised. This may, however, build too much caution

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into the valuation. An option with a very high cost may, in reality, be one that is unlikely
to be the most valuable for the individual or chosen the most.

For example a pension policy that provides a guaranteed rate for conversion of the policy
proceeds into an annuity at retirement should normally be valued using the guaranteed rate
if the option is or is close to being beneficial to the policyholder. However if there is also
an option to take part of the value of the policy as a tax-free lump sum, this latter option
may be more valuable to most policyholders, so that the majority choose it, even though
they are forgoing a financial benefit by not taking all the proceeds in the form of an
annuity at the guaranteed rate. In this case it may be that the take-up rate of the option
may be less than 100%. Furthermore the take-up rate may be different depending on the
purpose of the valuation and of prudence required.

6 Replicating portfolios
Using a “replicating portfolio” involves taking the fair (i.e. market) value of the liabilities
as the market value of the portfolio of assets that most closely replicates the duration and
risk characteristics of the liabilities. The replicating portfolio can be established by using
stochastic optimisation techniques, i.e. a form of asset/liability modelling. This approach
is the basis of the following two methods:

6.1 Market value method

This method is derived from financial economics. The inflation rate, discount rate and
related assumptions are derived from market information as follows:

 Assets are taken at market value.

 Liabilities are discounted at the yields on investments that match the liabilities – often
bonds.

 The bond yield may be based on government bonds or corporate bonds — the latter
will allow for credit risk.

 A better, but more complicated, approach would be to use term-standard discount rates
that vary over time to reflect the shape of the yield curve.

 The market rate of inflation is derived as the difference between the yields on suitable
portfolios of fixed-interest and index-linked bonds.

6.2 Bond yields plus risk premium

This method starts with using a discount rate based on bond yields as above, but then
adjusts it to take account of the returns expected on other asset classes as follows:

 Assets are taken at market value.

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 Liabilities are valued using a discount rate that is found by adjusting (usually
increasing) bond yields by the addition of either a constant or a variable equity risk
premium.

 Where a constant equity risk premium is used the result is the same as for the mark to
market method except that, all other things being equal, the value of the liabilities is
(usually) lower.

 It is more common to use a variable risk premium, which is derived by a combination

of market information and actuarial judgement.

 There is however a school of thought that taking account of the extra return from
equities is unsound unless account is also taken of the extra risk associated with
equities. As a result some actuaries argue that liabilities should only be valued using a
risk free rate of return (i.e. government bond yields).

7 Asset – based discount rate

An asset-based discount rate for the liabilities can be set where:

 Assets are taken at market value.

 An implied market discount rate is determined for each asset class, e.g. for fixed
interest securities it may be the gross redemption yield, for equities it involves
estimating the discount rate implied by the current market price and the expected
dividend and/or sale proceeds.

 The liabilities are valued using a discount rate calculated as the weighted average of
the individual discount rates based on the proportions invested in each asset class.

 The discount rate could be determined using the distribution of the actual investment
portfolio or the scheme’s strategic benchmark (if the current asset allocation is not
representative of the scheme’s usual investment strategy).

8 Stochastic deflators
The mathematical techniques relating to stochastic deflators are covered in subject CT8.
Stochastic deflators can be used to calculate values of assets and liabilities on a market-
consistent basis. A deflator is a stochastic discount factor which can be applied to a series
of cash flows under a set of realistic scenarios to produce market-consistent valuations of
assets and liabilities.

Because deflators are themselves stochastic functions, a different deflator is associated

with each possible real-world scenario in a stochastic model. The present value of the
future cash flows to which the deflators are applied is the expected value of the deflated

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cash flows. As stochastic deflators are based upon real-world scenarios, they can be set to
allow for the assessment of realistic risks.

9 Sensitivity analysis
The assumptions used for setting provisions are estimates of future experience, taking any
requirements for solvency capital into account. That is they will be the expected values
plus possible margins for adverse future experience. Sensitivity analysis can be used to
determine these margins.

Sensitivity analysis could also be used to assess the need and extent of any global
provisions that may need to be set up to cover potential future adverse experience.

When carrying out sensitivity analyses, it is important to change the assumptions singly, in
a logical manner. Normal practice is to start with a central set of assumptions, and then to
vary each item in turn, to quantify the effect of assumption changes. It is then also
necessary to test the effect of multiple assumption changes. In most cases the assumptions
will be neither fully independent nor fully correlated, and the result of applying two tests
simultaneously will be greater or less than the sum of the individual results.

10 Different methods of allowing for risk in cashflows

10.1 Best estimate plus margin
An approach to the uncertainty surrounding benefit costs and asset returns may be taken
by using assumptions that do not reflect an actuary’s “best estimate” of future experience.
A risk margin is built in to each assumption by using “best estimate” assumptions together
with an explicit margin for caution.

Assessment of the necessary margins depends on the risk involved, and its materiality to
the final result. Where a risk factor has been stable over many years and is not exposed to
economic events, it may be reasonable to add a simple percentage loading. An example
might be mortality risk for lives aged between 30 and 55 in developed countries.

In other cases a more detailed analysis of experience for various sources, perhaps using a
stochastic approach, may be needed to determine a margin consistent with the risk
appetite.

10.2 Contingency loading

This approach is to increase the liability value by a certain percentage. The choice of this
“contingency loading” is effectively another assumption and should ideally reflect the
degree of uncertainty that exists. It would, therefore, be expected to increase with the
value of the liabilities but not in a proportionate manner.

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Given the analysis tools now available, this approach is falling out of favour as
excessively arbitrary.

10.3 Discounting cashflows at a risk premium

This is the traditional discounted cashflow approach where the cashflows are assessed on a
best estimate basis, and then discounted at a rate of return that reflects the overall risk of
the project or liability. The techniques discussed in Unit 9 relating to the choice of risk
discount rate when assessing projects for investment are equally applicable when
determining a risk discount for provisioning purposes.

11 Different methods of allowing for uncertainty in the present

values of liabilities

If the population exposed to any particular risk is large enough, and the consequence of a
risk event is approximately normally distributed, then a mathematical approach to
establishing a provision for the risk will give a valid answer. A company establishing a
provision for notified theft claims under a household contents policy might simply provide
for the number of notified claims multiplied by the average cost of a claim in the last year.
This would give a best estimate provision. To establish a prudent provision that would be
sufficient at a ruin probability of any given percentage, a simple analysis of the normal
distribution will generate the required result.

However if the insured risks are rare events and also have a large variability in outcome,
then statistical analysis may break down. For example in establishing a provision for
notified motor accident personal injury liability claims, there is little alternative but to
carry out a case by case examination of the claim files to assess the extent of injury, the
prognosis, and hence the likely claim amount. Even this approach still leaves risk of
injury award inflation that a court might grant.

An alternative approach, especially in making provisions for risks which a provider has
accepted but where the risk event has not yet occurred, is to set a provision on the basis
that the premium charged is a fair assessment of the cost of the risk, expenses, and profit.
If a premium basis allows for 25% of the premium to cover expenses, commissions and
profit, then one approach to establishing a provision for the unexpired part of a years cover
is to assume that 75% of the premium covers risks equally through the period of the
policy. A provision for the unexpired duration can be set by a simple proportion of this
75%.

If a portfolio is such that there is no method of assessing a required provision with any
degree of confidence, this suggests that the risks ought to be transferred elsewhere.

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12 Equalisation reserves

A particular example of the issues discussed in the previous section occurs where a
product provider might wish to exhibit stable results from year to year, but where the
portfolio contains low probability risks with a large and highly volatile financial outcome.
In years where such an event occurs the company may show a significant reduction in
profits; where no event occurs, profits will be greater than the long term average.

To smooth results, a company may establish a claims equalisation reserve in years when
no claim arises, with a view to using the reserve to smooth results when a claim does
occur.

These reserves do not fit with the definition of a provision, but nevertheless are widely
used in general insurance. Tax authorities are often not prepared to take such reserves into
account in computing profits. Equalisation reserves are seen as a way of deferring profits
and hence tax.

13 Comparisons with market values

For many years actuaries valued future liabilities using discounted cashflow techniques
where long term assumptions are set. A key long term assumption is the future investment
return expected. The future cashflows arising from the liabilities are discounted to a
present value using this rate. For consistency with this approach, assets are also valued by
discounting future cashflows using long term assumptions. A major criticism of this
approach is that it places a different value on the assets from the market value, which
introduces an additional element of risk. Consequently methods that value liabilities on a
basis that matches that underlying the market value of the assets have been developed.

The risk free market value is the present value based on discounting future liability cash
flows 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 cash
flows and some estimation of yields in respect of notional longer-term assets has been
needed.

Financial risk associated with the liability cash flow is normally allowed for in a market
consistent manner either by a replicating portfolio (i.e. a portfolio of assets which exactly
matches the liabilities) or through stochastic modelling and the use of a suitably calibrated
asset model. 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.

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

 the amount of the risk

 the cost of the risk implied by market risk preferences

In the UK, market value approaches have made more rapid inroads into benefit schemes
than insurance companies. This is largely because in insurance industry there are many
accounting and regulatory standards and methods and it is taking a long time for these to
be accepted internationally.

Example

An expert witness is advising on a suitable discount rate to calculate the value of a lump
sum award to a 50-year old individual in compensation for his claim for loss of earnings
following an injury at work. The amount of the award is based on the annual earnings lost
and the number of years out of work and makes use of a discount rate in order to create a
present value. In previous cases the discount rate has been the real yield available on an
index of long dated index-linked government securities.

(i) Give reasons why the yield on a long dated index-linked government securities
index could be an inappropriate discount rate at this time.

(ii) It has been suggested that a more reasonable discount rate would be the expected
return above inflation on a portfolio of mixed assets. List the type of assets that a
typical individual investor would hold in such a portfolio and the factors that would
be considered in determining an appropriate discount rate.

Solution

(i) 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 (i.e. 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, e.g. 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 to 65.

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It may be appropriate to use a discount rate that is higher than the real yield on the
bond index. This is to reflect the uncertainties associated with the liabilities, e.g.
uncertainty over the duration of future employment.

Alternatively, these risks might be allowed for in the cashflows.

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 the 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 — i.e. supply and demand for the bonds.

(ii) 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
 security

END

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UNIT 18 — RELATIONSHIP BETWEEN ASSETS AND

LIABILITIES
Syllabus objectives

7.7.1 Describe the principles of investment and the asset/liability matching requirements
of the main providers of benefits on contingent events.

7.7.2 Discuss the use of portfolio theory to take account of an investor's liabilities.

7.7.3 Discuss the need to monitor investment performance and to review investment
strategy.

1 Principles of investment
The principles of investment can be stated as follows:

(1) A provider should select investments that are appropriate to the nature, term currency
and uncertainty of the liabilities and the provider’s appetite for risk.

(2) Subject to (1) the investments should also be selected so as to maximise the overall
return on the assets, where overall return includes both income and capital.

2 Asset-liability matching requirements — nature of liabilities

The net liability outgo consists of:

benefit payments
+ expense outgo
– premium/contribution income.

In practice the actual liability outgo in any year, or month, depends on the monetary value
of each of the constituents and the probability of it being received or paid out.
The benefit payments can be sub-divided into four types.

Guaranteed in money terms — This consists of benefit payments where the amount is
specified in money terms.

Guaranteed in terms of an index of prices, earnings or similar — This consists of benefits

whose amount is directly linked to an index. The index may not be a nationally published
one. For example the benefits accruing under a benefit scheme may increase in line with
pay awards granted by the sponsoring company.

Discretionary — This consists of any payments that are payable at the discretion of the
provider e.g. future bonus payments under with profit contracts or pension increases in
excess of guaranteed amounts.

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Investment-linked — This consists of benefits where the amount is directly determined by

the value of the investments underlying the contracts.

Expense payments tend to increase. The natural rate of increase is likely to fall
somewhere between price and earnings inflation. In addition there are exceptional items
which might be either expenditures or cost savings. For investment purposes it is adequate
to treat expenses as being linked to prices or earnings. Hence they can be included with
benefit payments guaranteed in terms of an index of prices or similar.

Premium/contribution payments may be:

 fixed in monetary terms and hence can be thought of as negative benefit payments
guaranteed in money terms

 or increase in line with an index and hence can be thought of as negative benefit
payments guaranteed in terms of an index

The existence of contracts or transactions where the client can vary the amount of
premium varies each year does not invalidate this.

The next sections consider the appropriate assets for each of these categories.

2.1 Guaranteed in money terms

A provider will want to invest so as to ensure that it can meet the guarantees. This means
investing in assets which produce a flow of asset proceeds to match the liability outgo.
This will involve taking into account the term of the liability outgo and the probability of
the payments being made, so as to indicate the term of the corresponding assets.

Except for certain types of liability, it will probably be impossible in practice to find assets
with proceeds that exactly match the expected liability outgo. In particular, the terms of
available fixed interest securities may be much shorter than the corresponding liabilities,
particularly when very long term pension liabilities are involved. A best match is all that
can normally be hoped for. The technique of immunisation (see below) may be used to
achieve this; but it is subject to theoretical and practical problems. A technically superior,
though more complicated, approach to assessing what a best match may be is discussed
below.

2.2 Guaranteed in terms of a prices index or similar

A suitable match would be index-linked securities, where available, ideally chosen to
match the expected term of the liability outgo.

2.3 Discretionary benefits

If discretionary benefits are to be provided the main aim of the provider will be to
maximise these and hence the investment strategy should therefore also aim to do that.
This means investing in assets that will produce the highest expected return.

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2.4 Investment-linked
The benefits are guaranteed to the extent that their value can be determined at any time in
accordance with a definite formula based on the value of a specified fund of assets or
index. The provider can avoid any investment matching problems by investing in the
same assets as used to determine the benefits. Replicating a market index may involve
holding a large number of small holdings and thus be too costly. Companies might choose
to use collective investment schemes or a derivative strategy to achieve this.

2.5 Currency
Liabilities denominated in a particular currency should be matched by assets in that
currency, so as to reduce any currency risk.

2.6 Free assets/surplus

The existence of free assets or a surplus means that the provider can depart from the
matching strategies outlined above so as to improve the overall return on its assets and
thereby benefit its clients, through higher benefits or lower premium/contribution rates,
and its shareholders (if any), through higher dividends (subject to some floor/trigger in the
event that any surplus is eliminated).

It is almost always the case that assets with the highest expected return also have the
highest variance of that return.

If the assets supporting guaranteed benefits are invested to produce the highest expected
return, the probability that the asset proceeds will become inadequate to meet the liabilities
may be too high and the risk of insolvency may be too great. This assumes that only
enough assets are held so that their expected proceeds will cover the benefits. If there are
free assets they can be used as a cushion to reduce the probability of becoming insolvent.

The techniques discussed below can be used to determine how much of the free
assets/surplus are needed as a cushion so as to reduce the probability of insolvency to an
acceptable level. Using free assets to maintain a deliberately mismatched policy has to
compete with other uses of free assets, in particular financing new business growth or
other new ventures. This often means that the opportunities to depart from a matched
policy for the guaranteed liabilities are limited.

It could be argued that matching assets to liabilities is irrelevant where there are
discretionary benefits, since a provider will want to invest in the securities with the highest
expected return anyway. On the other hand, although the benefits are discretionary,
beneficiaries will expect to receive them and moreover will have expectations as to the
level. The provider will therefore want to make use of some of the free assets/surplus, or a
limited matching strategy, so as to ensure that the probability of the discretionary benefits
falling below a particular level stays within acceptable limits.

It could be argued that it is a reasonable use of the free assets/surplus to mismatch

investment-linked benefits if by so doing the company can expect to achieve a higher

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return. If this is done any return achieved above that on the “matched” assets will not
accrue to the beneficiaries of the investment-linked contacts but to the provider. In many
territories, mismatching investment-linked benefits is disallowed by law or regulation.

2.7 Regulatory framework

The regulatory framework within a country may limit what a provider would like to do in
terms of investment. The following controls may be implemented:

 restrictions on the types of assets that a provider can invest in

 restrictions on the amount of any particular type of asset that can be taken into account
for the purpose of demonstrating solvency

 a requirement to match assets and liabilities by currency

 restrictions on the maximum exposure to a single counterparty

 custodianship of assets

 a requirement to hold a certain proportion of total assets in a particular class - for

example government stock

 a requirement to hold a mismatching reserve

 a limit on the extent to which mismatching is allowed at all

Where a mismatching reserve is required, the regulations are usually framed so that the
more a company decides to invest in riskier assets with a higher expected return, the
higher is any resulting reserve. This increases the value of the liabilities and reduces the
available free assets/surplus.

3 Matching assets to liabilities

Liability hedging is where the assets are chosen in such a way as to perform in the same
way as the liabilities. An example of this is immunisation, which is discussed in the next
section. Other familiar forms of hedging would include matching by currency and the
consideration of the real or nominal nature of liabilities when determining the choice of
assets. However, these examples relate only to specific characteristics of the liabilities,
whereas liability hedging aims to select assets that perform exactly like the liabilities in all
events.

A familiar example is the choice of assets to hold in order to hedge unit-linked liabilities.
In most cases the problem is “solved” by establishing a portfolio of assets, determining a
unit price by reference to the value of the asset portfolio, and then using this price to value
units held, allocated or realised.

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A problem arises if the assets held are not (or cannot be) the same as those underlying the
value of the liabilities. Thus, if units are allocated and realised by reference to some
external fund, then it is likely that the internal investment manager will not know what
assets are held by the external manager at any given point in time. Alternatively, the
requisite information may only be available after some delay, by which time the assets
actually held by the external manager may have changed.

An extreme example of this problem is where the value of liabilities is linked to some
external index (for example, “guaranteed” contracts where the movement of market
indices determines the value of the contract in some way). In order to hedge such
liabilities, use is often made of over-the-counter derivatives purchased from an investment
bank, thereby avoiding the uncertainty (and expense) of “rolling-over” short term
exchange traded derivatives over the lifetime of the underlying contract

4 Immunisation
Immunisation is the investment of the assets in such a way that the present value of the
assets less the present value of the liabilities is immune to a general small change in the
rate of interest.

The classical theory, due to Redington, depends on a considerable simplification of the

practical problem; it is assumed that, at a given moment in time, securities can be obtained
to yield a uniform rate of interest whatever the term. Furthermore, all the funds are
invested in fixed interest securities, which are either irredeemable or redeemable at a fixed
date.

Let Lt be the expected net outgo of the existing business in calendar year t, i.e. claims and
expenses less premiums (the “liability-outgo”). Lt can be positive or negative.

Let At be the expected proceeds from the existing assets in year t, i.e. interest plus
maturing investments (the “asset-proceeds”).

Let VL be the present value of the liability-outgo at the ruling rate of interest, so that
VL = vtLt

Let VA be the present value of the asset-proceeds at the same rate of interest so that
VA = vtAt

The conditions for immunisation are:

VA = VL ,

tvt At tvt Lt
 ,
vt At vt Lt

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and

t 2 vt At t 2 vt Lt
 .
vt At vt Lt

There are usually an infinite number of theoretical solutions to the equations, although
there may be no real solution for the asset-maturity dates available.

The conditions can be expressed in words as:

(i) The present values of the liability-outgo and asset-proceeds are equal.

(ii) The discounted mean term of the value of the asset-proceeds must equal the
discounted mean term of the value of the liability-outgo.

(iii) The spread about the discounted mean term of the value of the asset-proceeds should
be greater than the spread of the value of the liability-outgo.

There are several problems in putting the theory outlined above into practice:

Immunisation is generally aimed at meeting fixed monetary liabilities. Many investors

need to match real liabilities. However, the theory can be applied to index-linked
liabilities by using index-linked bonds.

By immunising, the possibility of mismatching profits as well as losses is removed apart

from a small second order effect.

The theory relies upon small changes in interest rates. The fund may not be protected
against large changes.

The theory assumes a flat yield curve and requires the same change in interest rates at all
terms. In practice the yield curve does change shape from time to time.

In practice the portfolio must be rearranged constantly to maintain the correct balance of:

(i) equal discounted mean term

(ii) greater spread of asset proceeds

The theory ignores the dealing costs of a daily (or even monthly) rearrangement of assets.

Assets of a suitably long discounted mean term may not exist.

The timing of asset proceeds and liability outgo may not be known.

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Example

Following the death of a relative, you have inherited a sum of money of approximately
five times your net annual salary. Your personal circumstances are as follows:

 You are working and belong to an occupational pension scheme.

 You have ten years to work before normal retirement.

 You are married with no children.

 You are a home owner with a mortgage.

 Your mortgage has five years to run and currently monthly mortgage payments
amount to around one-third of your net monthly income.

 You have cash savings amounting to approximately one year’s net salary.

 You use credit and store cards to manage cash flow on a monthly basis.

 You are in good health but have for some years taken part in a private healthcare
scheme.

(i) Using the details above and stating any additional necessary assumptions, describe
your assets and your liabilities excluding your inheritance.

(ii) Comment on the degree of matching between the two.

(iii) Suggest possible uses for your inheritance commenting briefly on the suitability of
the various options. You do not need to discuss the different types of asset that
might be used for investment.

Solution

(i) Assets

The house is part owned and may well represent a valuable real asset. Its value will
be heavily dependent on desirability of property and also local/national housing
market.

Pension provision is partially funded. This may be a defined benefit or defined

amount of money invested on your behalf.

The cash savings represent a further asset, likely to earn interest in future.
Future income is an asset. This could be assumed to be a non-decreasing stream up
until retirement at which point it will probably drop.

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The insured healthcare is an asset that will demonstrate “peace of mind” value at all
times and actual value in the event of qualifying ill health.

Liabilities

The outstanding mortgage debt repayment is a liability for the next five years.
Payments may be at a fixed rate or variable. Depending on the contract, final
payment may clear the debt or trigger a demand for a further sum to repay the loan
(perhaps to be settled with cash).

All future living expenses (including pension contributions if required) are a liability
and will be real in different ways.

The healthcare premium is a liability although the policy would be likely to be

renewable with the option to cease payment.

Store card debt could create additional liability if delayed payment led to interest
being incurred.

Tax (income, inheritance) should be factored into the liabilities as appropriate and
any tax relief added on to the assets.

(ii) The real income stream can be considered to be some sort of match for the real
expenditure stream. Close matching is not possible. Income will move with pay
policy of employer or pension terms in retirement whereas variety of inflationary
features impact on expenditure (price inflation, interest rate movements and
insurance premium inflation).

The mortgage repayments may well deliver final loan settlement. If further
repayment were required, other assets held (potentially the cash savings or cash
generated by moving house) would need to be used for payment.

Once the mortgage is repaid you have a further five years in employment, without
the need to finance mortgage payments. This will generate a significant increase in
net income for that period.

(iii) The investor would have to consider their attitude to risk. A low risk investor might
seek to match liabilities as far as possible (e.g. paying off mortgage as soon as
practical and then investing for retirement income).

A more aggressive investor might weigh up the opportunity cost of any money used
now to deflect liabilities and choose to invest if the expected return was attractive
(for example investing in new assets if expected return exceeded mortgage rate).

Regardless of the extent of the liabilities paid off, gearing investment to likely
retirement date (normal or early) would probably be desirable in order to reduce
impact of drop in income. A phased move from higher risk/higher expected return
assets (for example equities) to low risk, lower expected return assets (e.g. bonds)
over the period to retirement might be suitable.

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2016 Relationship between assets and liabilities Subject CA1

Other factors to consider include:

 tax position (the potential need to pay inheritance tax as well as income tax)
 the desire to invest in tax efficient investment products
 tax rate may drop on retirement because of reduced earnings
 the amount of money available to invest (may preclude direct investment)
 the costs associated with investing

5 Using portfolio theory to take account of an investor’s

liabilities

The extension of portfolio theory to take account of an investor’s liabilities is

straightforward. Instead of the return on a portfolio of assets at the end of a single period
or, equivalently the value of the portfolio, we can consider the size of the excess of assets
over liabilities i.e. the surplus. This can be written as

n
S  A  xi (1  Ri )  L ,
i 1

where S is the surplus at the end of the period

A is he value of the assets at the start of the period
xi is the proportion invested in security i
Ri is the return on security i
L is the projected value of the liabilities at the end of the period

Mean-variance portfolio theory can then be applied to minimise the variance of the surplus
for a given expected return, treating the liability as a negative asset.

In practice it will be necessary to decide how to place values on the liabilities and to
determine, not only the expected value of the liability at the end of the period, but also its
variance and covariances with the assets. One way of doing this is to use a stochastic asset
liability model.

6 Monitoring investment performance and strategy

It is necessary to review the continued appropriateness of any investment strategy at
regular intervals because:

 The liability structure may have changed significantly (for example following the
writing of a new class of business, a takeover, benefit improvements or legislation).

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Subject CA1 Relationship between assets and liabilities 2016

 The funding or free asset position may have changed significantly (free assets or
surplus may have reduced), or

 The manager’s (or the vehicle’s) performance may be significantly out of line with
that of other funds.

It is likely that an investment manager will work to a performance objective in which the
return is judged relative to that achieved by other managers for similar funds. The more
severe the restrictions placed on the managers as to the assets or asset classes that can be
held, the less appropriate it is to set performance targets that relate directly to the
generality of funds. A comparison of the return achieved with the valuation discount rate
will also be inappropriate, due to the volatility that will occur in returns from year to year.
The target return should therefore be compared against that which will have been achieved
by an index fund, which had maintained the asset allocation proportions set in the
benchmark.

It is also important to note any other constraints that may have affected the manager’s
performance, such as a shortage of cashflow within the provider. This may restrict the
funds available for investment or lead to disinvestments that may not be timed as well as
would otherwise be the case.

END

Unit 18, Page 10 © Institute and Faculty of Actuaries

2016 Maintaining profitability Subject CA1

UNIT 19 — MAINTAINING PROFITABILITY

Syllabus objectives

8.1 Describe how the main providers of benefits on contingent events can control and
manage the cost of:

 payments arising on contingent events

 expenses associated with the payment of benefits on contingent events

1 Controlling and managing benefit payments and expenses

There are various ways in which providers can control and manage the cost of the
payments they make and their expenses. For example:

 Where payments are made under an income protection arrangement that provides
benefits on incapacity then costs can be controlled by requiring the beneficiary to
provide ongoing proof of eligibility for the benefit.

 A benefit scheme can control costs by not guaranteeing regular benefit increases but
only giving discretionary increases as and when they can be afforded.

 A general insurer can control costs by offering discounted premiums in future years to
policyholders who do not make claims. Similarly they can reduce the number and
amount of claims by introducing an excess into the product design. This will mean
that the policyholder will pay the first part of any claim.

 If a provider is able to change any expense charge it makes to the customer within the
product design then costs can be passed on in this way.

 A Government could reduce costs by taking a unilateral decision to raise the age at
which the state pension becomes payable.

A provider can manage the expenses associated with benefit payments, by ensuring that
the costs of claims management are commensurate with the cost of the claim.

For example a motor insurer is likely to accept without question a single estimate from a
garage for damage repairs up to say £500. For larger sums, up to perhaps £1,000, the
insurer might require more than one estimate to be submitted, or alternatively the work to
be carried out by the insurer’s own approved repairer. If the vehicle is a write-off, or if a
personal injury claim is involved, the insurer is likely to appoint professional loss adjusters
to assess the claim on their behalf, and to negotiate a settlement figure.

With a permanent health insurance claim, the amount of medical evidence that an insurer
will require before accepting a claim will depend on both the amount of weekly or
monthly benefit, and the expected duration of the illness or condition. A potentially

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Subject CA1 Maintaining profitability 2016

chronic condition can justify considerably more time and costs in claims assessment than
an acute illness of limited duration.

Example

A defined benefit pension scheme has a 1/80th accrual rate and provides benefits based on
prospective service to age 65 for members who retire on ill-health grounds. Membership
of the scheme is voluntary.

(i) Discuss the advantages and disadvantages for the employer of the following options
in connection with the benefits on ill-health retirement to be provided to employees
who do not join the plan when they start employment:

 offer membership at any time with no regard to medical evidence

 only permit membership on receipt of satisfactory medical evidence
 offer membership but with some adjustment to ill-health benefits

The employer has proposed using the third option set out in (i). It has been suggested that
an unadjusted early retirement pension be granted in respect of past service in the scheme
at the date retirement occurs. However in respect of future potential service the pension
should be reduced in line with the proportion that completed service as a member of the
scheme bears to completed service with the employer.

(ii) Considering an employee who commenced employment on their 25th birthday but
joined the plan on their 40th birthday;

Compare the benefit arising under this proposal if ill-health retirement occurs at ages
40, 50, 60 and just prior to the 65th birthday with the pension that would have been
granted if no adjustment to the ill-health benefits was made.

(iii) Comment on the employer’s proposal.

Solution

(i) If membership is offered at any time with no regard to medical evidence this will be
easy for the members and administrators. However, it will leave the scheme open to
anti-selection. If members only join the scheme when they become aware of illness,
this would lead to a significant strain on the fund.

If membership is only permitted on receipt of satisfactory medical evidence then a

decision will be needed on who will provide medical evidence, a doctor appointed
by the scheme or the employees own doctor. This might lead to conflicts and
aggrieved employees. It may be better to have a scheme doctor but then there will
be additional costs involved. However, once a member has been accepted into the
plan the administration will be relatively straightforward.

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2016 Maintaining profitability Subject CA1

If membership is offered with some adjustment to ill-health benefits a robust scale

will need to be set for the adjustments and consistent rules must be applied to
different members. The administration of this arrangement will be more
complicated than for the other two options.

(ii) Age at entry to employment 25

Age at entry to plan 40
Consider retirement at age x

Without any adjustment, the ill-health pension at all ages would be:

(65  40)
= 31.25% of final salary
80

Under the employer’s proposal:

1  ( x  40) 
Pension =   ( x  40)   (65  x) 
80  ( x  25) 

x x  40 x  25 65  x Pension (%) Comparison (%)

40 0 15 25 0 0
50 10 25 15 20.00 64
60 20 35 5 28.57 91
65 25 40 0 31.25 100

(iii) As the age at which ill-health retirement approaches the normal retirement age of 65,
the benefit arising from the employer’s proposals moves asymptotically towards the
benefit that arises if the member was treated as if he had joined employment and the
scheme at age 40.

Therefore, the employer’s proposal protects the scheme from the selection problems
identified in part (i). However, it gives less beneficial treatment for longer service
employees who do not join plan at first opportunity compared with the benefits
offered to new employees who join the scheme at the same age. The benefit will be
quite complicated to explain to members and may give rise to complaints. It will be
cheaper for the employer than the first option in (i) as the pension is lower.

Example

A life insurance company has an established portfolio of income protection business,

which provides an income to policyholders during periods of incapacity due to sickness. It
is considering implementing a claims management process, where health professionals are
used soon after a claim is notified to the insurer to treat the claimants and help them back
to work. The process will also be used on the claims currently in payment.

Describe the potential impact of this proposal on the claim inception and termination rates.

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Subject CA1 Maintaining profitability 2016

Solution

The implementation of a claims management process should, in the short term, lead to an
increase in claim termination rates, since some of the claims currently on the books are
likely to be terminated as a result of the intervention by health professionals.

The treatments given should lead to some claimants returning to work sooner than they
otherwise would have done. (In some cases, without appropriate treatment, claimants may
have continued to claim until retirement.)

There will be a reduction in claim inception rates — since some of the claims notified to
the insurer during the deferred period, which in the past would have been admitted, will no
longer be made as a result of the early intervention by health professionals.

In the longer term, claim inception rates should remain lower than the rates experienced
prior to the introduction of the claims management process, as a lower proportion of the
claims notified will actually be made. In addition, the company may find that once
policyholders and intermediaries become aware of the claims management process,
borderline claimants may be discouraged from claiming — so the actual number of claims
notified may decrease.

Termination rates may then stabilise, since the type of claims that led to a reduction in
claim imception rates in the short term will no longer be made. The claims management
process should weed out some claims at an earlier stage and so more of claims that are
made will be “genuine” claims. It is likely that the termination rates of these “hard core”
claims will be lower than for the aggregate portfolio prior to the process being introduced.
Therefore, overall the introduction of the claims management process should lead to lower
claim inception rates, a short-term improvement in the claim termination rates but in the
long term potentially slightly worse termination rates.

END

Unit 19, Page 4 © Institute and Faculty of Actuaries

2016 Determining the expected results Subject CA1

UNIT 20 — DETERMINING THE EXPECTED RESULTS

Syllabus objectives

8.2.1 Describe how a provider’s expected results can be projected.

8.2.2 Discuss the possible sources of surplus/profit and the levers that can control the
amount of surplus/profit.

1 Projection of expected results

In order to analyse the actual performance of any financial structure, ranging from a single
product type to a complex product provider, it is necessary to determine the expected
values against which the actual values can be compared.

When analysing the results of a product provider it is usually necessary to project items
such as the revenue account and balance sheet as if the actual experience had been the
same as that expected when its business was written. This involves building a model of
the expected future experience of the provider.

The bases for such an exercise are likely to be the models used when the products were
developed. The results of the initial product pricing models can be combined to build a
complete model of the provider’s future revenue accounts. It is important in building such
a model to ensure that the elements of the revenue account are self-consistent in their own
right. It is not sufficient to project premiums, investment income, death claims, lapses etc.
independently.

The model is developed by multiplying the profit test results by the expected number of
contracts to be sold in each future year. Then for each future year the number of contracts
still in force from previous years needs to be added in. This will then give a model that can
be used to build up the expected future progress of the business as shown by the revenue
accounts.

As time goes on, a second model can be built up from the original profit test, but using the
actual volumes of business sold, rather than expected volumes. Comparisons of actual
results with this model will identify whether differences between actual and expected
outcomes are due to differences between actual and expected experience, or due to sales
volumes being different from expected.

The actual revenue accounts for the business showing the actual experience of the provider
can then be compared with the projections. This analysis will show how the actual
experience compares with that anticipated when products were designed and answer
questions such as:

 Has the provider earned more by the way of investment than it expected to earn when
it designed the product?

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Subject CA1 Determining the expected results 2016

 Has the provider spent more than it allowed to be spent in the design of the product?

The answers to such questions will give an initial indication of whether the profitability
criterion used in designing the product in the first place is being met in practice. This can
be used as feedback information in the actuarial control cycle.

2 Possible sources of surplus/profit and the levers that can

control the amount of surplus/profit
In determining premiums, contributions and provisions for future liabilities, assumptions
will need to be made. Where actual experience differs from the assumptions made a
surplus/profit (or deficit/loss) will arise.

Possible sources of such surplus/profit (deficit/loss) include:

 mortality
 morbidity
 withdrawal/lapses
 investment income and gains
 expenses
 commission
 salary growth
 inflation
 taxation
 premiums/contributions paid
 new business levels
 claim amounts

The levers that can control the amount of surplus/profit are the factors that the provider
can affect by using management controls to increase value. For example the management
can try to:

 control expenses

 reduce the number of contracts that lapse

 reduce the likelihood of claims through good underwriting of new business

 use reinsurance to limit the volatility of claims or to protect from the risk of large
claims

 follow an investment policy that increases investment returns (subject to an acceptable

level of risk)

 increase the number of policies that renew at the renewal date

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2016 Determining the expected results Subject CA1

 adopt an effective tax management policy

END

© Institute and Faculty of Actuaries Unit 20, Page 3

2016 Reporting actual results Subject CA1

UNIT 21 — REPORTING ACTUAL RESULTS

Syllabus objectives

8.3.1 Describe the reports and systems which may be set up to control the progress of the
financial condition of the main providers of benefits on contingent events.

8.3.2 Describe the reports and systems which may be set up to monitor and manage risk at
the enterprise level.

8.3.3 Discuss the issues facing the main providers of benefits on contingent events
relating to reporting of risk.

1 Accounting concepts
Accounting concepts and principles may vary from country to country, although efforts
are being made to achieve greater harmonisation of international accounting practice. The
principles used may also depend on the purposes for which the accounts are designed.

In recent years Accounting Standards have placed greater emphasis on neutrality, rather
than prudence, and there has also been a move away from historical cost towards “fair
values”.

In very broad terms, this means revaluing assets (and liabilities) in the statement of
financial position at the end of each accounting period. Any loss on revaluation should be
included in that period’s income statement. Any gain on revaluation is taken to the
revaluation reserve in the statement of financial position, where it is held until the gain is
realised (i.e. the asset is sold). A consequence is volatility in the financial statements and
so this move is controversial.

The following accounting concepts were introduced in CT2 — Finance and Financial
Reporting:

 cost
 money measurement
 going concern
 business entity
 realisation
 accruals
 matching
 dual aspect
 materiality
 prudence
 consistency

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Subject CA1 Reporting actual results 2016

Candidates are not expected to be familiar with the accounting concepts and principles that
apply in any particular country. They may be expected to discuss problems that arise in
defining accounting concepts and principles and putting them into practice, and the
implications for the interpretation of providers’ accounts.

2 Interpreting accounts

2.1 Analysis of accounts

The examiners will expect candidates to be able to comment sensibly on the conclusions
(if any) that can be drawn from analysing a simple set of accounts, making reference
where necessary to the effect of the strength of bases, business growth, etc.

Before attempting to interpret the accounts of a provider, it is necessary to be familiar with

the rules governing the preparation of the accounts and also the accounting rules and
conventions that apply in the country concerned.

Though subject to variation from country to country, the published financial statements of
providers are usually prepared on a going concern basis and are intended to give a true and
fair view of the provider’s performance and financial position. They need to be examined
to see whether they have been affected by any changes in accounting practice and, if so, to
find what the effects of such changes may have been.

Attention needs to be paid to the basis used for the valuation of the assets, and the
treatment in the accounts of realised and unrealised capital gains and losses. If assets are
shown at market value, consideration should be given to the vulnerability of the asset
values to changes in market conditions.

The reports accompanying the accounts may reveal the extent to which the results for the
latest period have been affected by the occurrence or non-occurrence of exceptional
events.

2.2 Insurance companies

Insurance business is subject to cyclical effects that may affect many providers at more or
less the same time. This makes it necessary to compare the profitability of a provider’s
business (as distinct from the profit disclosed by the latest set of accounts) with the results
disclosed by the accounts of other providers, especially those transacting similar types of
business.

In practice it is often difficult to prepare the accounts in accordance with the consistency
concept because of the uncertainty in determining the various items in the accounts, in
particular the provisions. If the provisions established at the end of the year are weaker, in
relation to current conditions, than those established at the end of the previous year, the
profit for the year will have been overstated, and vice versa. The same applies, of course,
to the accounts of any other providers that may be used as a basis for comparison.

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2016 Reporting actual results Subject CA1

It may be possible to get an indication of the strength of the provisions by examining

individual accounting items (both gross and net of reinsurance, if separate figures are
available) and various ratios of one to another, and comparing them with the accounts of
earlier years. The extent to which this is feasible will depend on the amount of detail
given in the financial statements. Among the ratios to be considered could be:

 incurred expenses to premium income

 commission to premium income
 operating ratio
 outward reinsurance premium income to gross premium income

A sharp rise in premium income may be a sign of competitively low, and perhaps
unprofitable, premium rates.

2.3 Benefit schemes

Reporting on the progress of benefit schemes is different from the reporting of results by
corporate entities. Benefit schemes do not generate profits or losses, indeed if actuarial
valuations of the scheme are not made annually, there are no entries that can be made on
the liability side of the balance sheet of a benefit scheme, other than “accumulated fund”.

It is the results of the actuarial valuation of the scheme that generates a figure for
accumulated surplus or deficit. This amount may be used to adjust the contribution rate
for the succeeding period.

In many countries, it is recognised that it is important that the beneficiaries are given
sufficient information about their entitlements. This disclosure to beneficiaries is also
commonly used as a legislative requirement as a means of attempting to improve the
security of non-State provision.

Disclosure could include details of the benefit entitlements, the contribution obligations,
the expense charges, the investment strategy, the risks involved and the treatment of
entitlements in the event of insolvency. Guidance or legislation on the precise form of the
disclosure of such information is important in ensuring that the beneficiaries are not
misled, either intentionally or unintentionally. For example, there may be a need for
careful specification of the allowance that should be made when projecting the future
growth of benefits due to further accrual or inflationary growth. Expense charges are
another area in which care will be needed to avoid confusing the beneficiary.

Where disclosure is required by legislation, this may relate to information given to

beneficiaries on entry, at regular intervals, once payments commence, on request, or a
combination of these.

Disclosure may be important to providers as well as to regulators. Well designed

information can help to encourage individuals to make non-State benefit provision.
Although it is largely the form of the benefits that will dictate how well it is to be
understood by members and potential members, it is usually possible to present the same
set of benefits in a few different ways, some of which may be clearer to members than
others.

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Subject CA1 Reporting actual results 2016

Poor disclosure can lead to future problems for providers, as they may give rise to the
beneficiaries gaining false expectations of their future benefits.

Where benefits are sponsored by employers, it is important that the owners of the capital
of the company (and potential owners) are aware of the financial significance of the
benefit obligations that exist. It is therefore common practice in many countries for these
financial obligations to be shown as part of the company’s formal accounts.

In presenting benefit costs in the accounts it is important that the readers of the accounts
are able to form a realistic opinion of the company’s current and future financial position.
A number of different accounting standards exist, however there are some common aims
that most of these standards attempt to achieve:

 recognising the realistic costs of accruing benefits

 avoiding distortions resulting from fluctuations in the flow of contributions from the
employer to the pension scheme

 consistency in the accounting treatment from year to year (although not necessarily
from company to company)

 disclosure of appropriate information

Differences that exist relate to:

 the emphasis on the relative importance of the balance sheet and the income
statements in demonstrating a true financial picture

 the choice of actuarial methodology

 the flexibility in the setting of assumptions

 the smoothing of year on year fluctuations

 the amount of information to be disclosed

Possible disclosure requirements that may be needed:

 the assumptions used

 the actuarial method used
 the value of liabilities accruing over the year
 the increase in the past service liabilities over the year
 the investment return achieved on the assets over the year
 the surplus deficit
 the change in the surplus deficit over the year
 the benefit cost over the year in respect of any directors

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2016 Reporting actual results Subject CA1

 membership movements

3 Reports and systems at the enterprise level

Unit 3 of this course discussed the advantages of managing and budgeting for risk at the
enterprise level. By budgeting for risk across the whole enterprise, maximum use can be
made of diversification benefits, and thus the minimum capital be needed to support the
risks undertaken.

One of the consequences of this approach is that it is necessary to have a system of risk
reporting across the whole enterprise. It is important for the chief risk officer to be aware
of whether all business units are using the risk allocation that they have been given. If two
business units are allocated risk exposures that diversify away at the enterprise level but
one of the two units does not take on the risk exposure allocated, this could actually
increase the capital requirements of the enterprise. Risk exposures will not be matched,
and additional capital will have to be held to cover the unbalanced risks taken on.

4 Reporting on risk
The usual way for a financial product provider to report on risk is by quantifying the
capital required to protect against ruin at a given ruin probability.

This is normally carried out using a combination of stochastic and deterministic modelling
techniques. A common approach is to use a stochastic model to determine the risk event
at the required ruin probability, and then to run a deterministic projection using that risk
event. For example a stochastic asset model might be used to determine that a fall in the
domestic equity market of 45% in one year occurs with a 0.5% probability. In assessing a
market risk capital requirement with a ruin probability of 0.5%, the company’s projection
models would be ruin assuming an equity fall of 45% in the first year.

Details of the techniques involved in calculating the capital assessment are covered in the
ST subjects. The main issues facing providers of financial benefits in completing the
assessment are:

 Should the ruin probability be expressed over a single year or over the whole run-off
of the business? In the latter case the ruin probability will be a much higher figure
than in the former.

 As discussed in unit 12, a stochastic model with more than two stochastic variables
will be impractical to run. Thus a means of assessing the correlation between the risks
assessed needs to be developed. The most common technique uses a correlation
matrix. Populating the correlation matrix is a largely subjective exercise.

 Interactions between risks may mean than the effect of multiple risk events is greater
or less than the sum of the individual risks. A practical technique needs to be
developed to address this.

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Subject CA1 Reporting actual results 2016

 Some risks, particularly operational risk, are still highly subjective in their assessment,
particularly when it is necessary to construct a plausible adverse scenario that occurs
at a very low probability. The temptation is to think of risk events that have occurred,
which are therefore likely to be more common than the required ruin probability.

 Using past data to estimate future consequences of rare events needs to be undertaken
with caution. For example the 1918–1919 Spanish Flu pandemic has been assessed as
an event with a probability of between 0.5% and 1%. However, because of advances
in medical science, particularly the discovery of antibiotics, it is estimated that the
same number of deaths as in 1918–1919 would now occur only from a much rarer
event, perhaps one with 0.1 to 0.2% probability.

END

Unit 21, Page 6 © Institute and Faculty of Actuaries

2016 Asset, capital and surplus management Subject CA1

UNIT 22 — ASSET, CAPITAL AND SURPLUS

MANAGEMENT
Syllabus objectives

8.4 Describe the principles of asset management and allocation.

8.5 Describe the principles of capital management.

8.6.1 Describe why a provider will carry out an analysis of the changes in its
surplus/profit.

8.6.2 Describe how any surplus/profit arising may be distributed.

8.6.3 Discuss the issues surrounding the amount of surplus/profit that may be
distributed at any time and the rationale for retention of surplus/profit.

1 Portfolio construction and benchmarking

Units 16 and 18 deal with the strategic issues surrounding investment management, and
the matching of assets to liabilities. This unit considers the management of a particular
asset portfolio.

In managing an investment fund, managers will often face two conflicting objectives:

 to ensure security
 to achieve high long-term investment returns

The first objective encourages a cautious approach, where the assets chosen follow the
benchmark or target, while the second encourages a move away from the benchmark into
assets that are expected to generate higher returns, although with a higher associated risk.

The investment policy therefore needs to reflect the extent to which the risks of lower
stability and security are to be taken on in order to aim for higher returns. This will
typically involve a two-stage process:

Establishing an appropriate asset mix for the fund — the strategic benchmark. This will
be set taking into account the nature of the liabilities, and any representations about the
structure or asset mix of the fund that have been made to investors. The various tools
described in Units 16 and 18 will be used in setting the strategic benchmark. The strategic
(or policy) risk of the fund is the risk of poor performance of the strategic benchmark
relative to the value of the liabilities.

This strategy can be implemented by the selection of one or more managers, and a
decision on the appropriate level of risk that these managers should take relative to the
strategic benchmark. Within their guidelines, the investment managers have freedom over
stock selection, and use their skills and research to maximise the return on the funds

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Subject CA1 Asset, capital and surplus management 2016

allocated to them. The allocation of this part of the investment risk budget is known as the
active (or manager or implementation) risk.

There may also be some structural risk associated with any mismatch between the
aggregate of the portfolio benchmarks and the total fund benchmark.

The overall risk is the “sum” of the active, strategic and structural risks. Unless a scheme
is very small, structural risks can be made very small, particularly if “peer group”
benchmarking is avoided.

2 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.

2.1 Financial Reinsurance (FinRe)

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.

2.2 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.

2.3 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, i.e. the repayment of the debt is guaranteed only
after the policyholders’ reasonable expectations have been met. The debt can be dated or
undated, though this will impact the amount available as an admissible asset and may
impact the tax implications.

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.

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2016 Asset, capital and surplus management Subject CA1

2.4 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, which can be used to provide short term financing for companies
facing rapid business growth.

 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 (i.e. it is provided when it is needed).
Although these arrangements clearly improve the financial strength of an insurer and
can be given credit for by a rating agency, they lack visibility.

 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.
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.

 Derivatives provided by banks, some of which may be highly structured, may also be
used for capital management (also see below).

2.5 Derivatives
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. 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.

2.6 Equity
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, from
existing shareholders by a rights issue or directly from the market by a new placement of
shares.

2.7 Internal
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

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Subject CA1 Asset, capital and surplus management 2016

 the distribution of surplus could be deferred

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

3 Analysis of the change in surplus/profit

Because of the long term nature of financial services contracts, the final profit from a
scheme or tranche of policies cannot be determined until all have gone off the books.
Waiting until this happens before the terms under which the next tranche of policies are
written can be determined is clearly impractical. To monitor the progress of the business it
is necessary to value the outstanding liabilities from time to time, often annually. A
provider will want to analyse the change in any surplus arising over a year or a longer
period of time in order to:

 Show the financial effect of divergences between the valuation assumptions and the
actual experience.

 Determine the assumptions that are the most financially significant.

 Show the financial effect of writing new business.

 Validate the calculations and assumptions used.

 Provide a check on the valuation data and process, if carried out independently.

 Identify non-recurring components of surplus, thus enabling appropriate decisions to

be made about the distribution of surplus.

 Reconcile the values for successive years.

 Provide management information.

 Provide data for use in executive remuneration schemes.

 Provide detailed information for publication in the provider’s accounts.

 To demonstrate that the variance in the financial effect of the individual levers is a
complete description of the variance in the total financial effect.

 To give information on trends in the experience of the provider to feed back into the
actuarial control cycle.

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2016 Asset, capital and surplus management Subject CA1

4 Distribution of surplus/profit
For with profits life assurance business some or all the distributable surplus is allocated to
policyholders in the form of bonuses. The structure of the bonus and the manner in which
it is paid is determined by the terms of the policies and the constitution of the company.
The constitution of the company may also determine the maximum proportion of the
distributed surplus that can be paid to shareholders. In some jurisdictions this is
determined by legislation. A mutual insurance company has no shareholders and thus all
the distributable surplus belongs to the policyholders.

For all other corporate institutions the surplus belongs entirely to the shareholders, and the
only decision the directors of the company have to make is the extent to which it is
retained in the business or distributed as dividends to shareholders.

For benefit schemes any surplus is usually retained within the scheme, and may be used to
enhance the benefits of members, or to reduce future contributions of members and/or the
employer. Because it is usually difficult to remove benefit enhancements once awarded,
changes in contribution rate are normally the first choice. In some jurisdictions it is
possible for surplus to be repaid to the scheme sponsor, and in others it is not.

5 The amount of surplus that may be distributed at any time

5.1 Life insurance companies
For a life insurance company the factors that will affect the amount of surplus distributed
are:

 provision of capital
 margins for future adverse experience
 business objectives of the company
 policyholder expectations

5.1.1 Provision of capital

There are a number of reasons why life insurance companies need capital. These are
discussed elsewhere in the course. One of the main sources of working capital is simply to
defer profit distribution and retain the capital within the business.

Where with profits policies are involved, there are a number of additional considerations.
The premium rates for with profits policies are greater than those for without profits
policies because the former contain margins designed to generate profit that will then be
distributed to policyholders. The pace at which the profit arises and the pace at which it is
distributed may or may not be the same. If part of the profit is deferred to some future
date before being distributed then it will augment the company’s free assets in the
meantime.

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Subject CA1 Asset, capital and surplus management 2016

Where profit is not being distributed as and when it arises, there will be years when the
amount distributed exceeds the amount generated and vice versa. However, over time it
would be expected that there should be a balance between the two. Sustained over-
distribution could, though, lead to an excessive drain on the free assets. Sustained under-
distribution is likely to be contrary to policyholders’ expectations.

The extent to which it is possible to defer the distribution of profit depends on the form of
the distribution.

5.1.2 Business objectives of the company and retention of margins

A with profits life insurance company is likely to have as one of its business objectives the
maximisation of the profit distribution to policyholders so as to improve its competitive
position by demonstrating good returns for the premiums invested. However an
aggressive distribution policy will result in the company having very limited free assets,
and thus limited ability to survive risk events.

The converse position is equally important. A company that retains more surpluses than
necessary to protect against risk events, ensure solvency, finance business growth and
allow appropriate investment freedom may find securing new business more difficult
because of the poorer returns it is able to generate..

5.1.3 Policyholder expectations

Policyholders and shareholders may have expectations as regards the form of the profit
distribution and the level of the bonuses or dividends given. Failure to meet these
expectations will lead to policyholder dissatisfaction and the risk of losing existing and/or
new business. It may also in some countries, for example the UK, be a ground for
intervention by the insurance supervisory authority in the affairs of the company.

5.2 Benefit schemes

For a benefit scheme, legislation is likely to be the major factor in determining the
application of surplus or deficit. If a benefit promise has been made, legislation may insist
that the benefit is provided whether or not any funds set aside prove to be sufficient.
There may therefore be a legal obligation on a sponsor to make good any deficit, even if
doing so results in the insolvency of that sponsor, and affects other interests of employees,
such as their continued employment. Benefit scheme deficits may also have a prior
ranking in the event of the sponsor’s insolvency. Legislation may also require surplus to
be used to increase the benefits being provided, and may even dictate which categories of
members should have priority for such increases.

Where the funds set aside are subject to a beneficial tax treatment, it is possible that
surplus funds may be excluded from this beneficial treatment. It is also likely that the
sponsor would be required to pay tax if receiving a return of surplus funds.
Where legislation does not restrict the application of surplus or deficit, the sponsor can
choose to place restrictions on the use of surplus, deficit, or both when setting up the
scheme through which the benefits are provided. This may have been done as a
reassurance to the potential beneficiaries that the benefits will be provided even if the fund

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2016 Asset, capital and surplus management Subject CA1

suffers from adverse experience, or it may have been done as an attempt to prevent
disputes were deficits or surpluses to arise.

If there are no detailed restrictions from the State or in the rules of the scheme, the sponsor
or the managers of the fund may be able to choose how to apply any surplus or deficit.

In making these decisions the risk exposure of the various parties may be considered. For
example, if the sponsor is exposed to the risk of making good any deficit, it may be felt
that the sponsor should take the benefit of any surplus. There may be situations where it is
necessary to take legal advice before dealing with any surplus or deficit.

The source of the surplus or deficit may also be taken into consideration, particularly when
applying the surplus or deficit to a certain category of beneficiary. For example, in a final
salary pension scheme a surplus may arise as a result of pension increases being lower, in
real terms, than was expected. In these circumstances it may be decided to use the surplus
to increase pensions for pensioners, perhaps restoring their value in real terms. If the
surplus or deficit is from a source that is liable to particularly volatile experience, the most
appropriate application of the surplus or deficit may be to retain it as a balance for future
volatility. This approach is perhaps more likely to be adopted in the event of surplus,
rather than deficit where such an approach may not be prudent. It is also more likely when
the surplus or deficit is small relative to the total value of the assets or liabilities.

Where surplus is to be applied to the advantage of the sponsor, or deficit is to be made

good by the sponsor, a further decision would be required relating to the pace at which this
will happen. It is likely that the speed of removal of deficit would be required or expected
to be faster than for the removal of surplus. A common approach adopted for pension
benefits may be for a deficit to be removed over a period of, say 5 years and a surplus to
be removed over a longer period, perhaps the remaining working lifetime of current
employees with a benefit entitlement.

Another factor that may affect a decision on the application of surplus or deficit may be
the expected effect of that decision on industrial relations. A sponsor may therefore make
a decision that is more generous to beneficiaries than may otherwise seem necessary.

END

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2016 Insolvency and closure Subject CA1

UNIT 23 — INSOLVENCY AND CLOSURE

Syllabus objective

8.7 Discuss the issues which need to be taken into account on the insolvency or closure
of a provider of benefits on contingent events.

1 Insured arrangements
Because insurance companies are normally subject to some form of State regulation, they
are usually required to maintain a level of solvency capital. There are also regular
reporting requirements that enable the regulator to monitor the financial position of
companies. These are designed to enable the regulator to be in a position to intervene in
the running of a company before it reaches the position of being unable to meet its
liabilities.

Consequently, in such environments, insurers rarely become insolvent. What happens is

that the required level of solvency capital is breached and the regulator intervenes to
protect the interests of existing or prospective policyholders. If the insurer’s financial
position is serious, then the regulator may require it to close to new business, so that new
policyholders are not entering a fund whose solvency may be in doubt. In most cases, the
company will be required to establish a recovery plan, and this will be monitored closely
by the regulator.

If a provider closes to new business it will still have outstanding liabilities from the
business written that will need to be met. However in these circumstances it should be
possible to make significant cost savings. These, coupled with the release of capital
previously tied up in financing the new business strain of the business on the books,
should enable the company to meet these liabilities in the short term. However in the
longer term, diseconomies of scale will bite and further actions will be needed.

The insurer may be sold to or merge with another provider who takes on the liabilities.

In any of these scenarios it will be important to project the insurer’s solvency position into
the future on a range of deterministic scenarios, or with the aid of a stochastic model. It
will be important to estimate the actions that might be taken in various scenarios, and to
include these in the model. The issues that need to be addressed and modelled include:

 estimation of future profits available to equity shareholders, net of tax

 the current value of all surplus assets
 the amount, and timing, of any loan or debt redemption
 problems of staff relationships (and redundancies)
 considerations relating to staff benefit schemes — particularly if schemes are in deficit
 outstanding financial obligations, minority interests, tax

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Subject CA1 Insolvency and closure 2016

If there is an acquiring company prepared to take over the business, it will be necessary to
consider:

 the location of the operation

 any integration of the systems platform
 relocation of staff or whether there an adequate labour force available
 the effect on unit costs

Where an insurer cannot meet its liabilities (as opposed to not having adequate solvency
capital), and a buyer cannot be found to take them on, there may be a statutory scheme set
from which some or all of the benefit payments are paid. Such a scheme is usually funded
by a levy on all other providers.

2 Sponsored benefit schemes

2.1 Level of benefits
Where a benefit scheme is set up to provide benefits for a group of individuals,
consideration needs to be given to the benefits that would be payable were the scheme to
cease. This may arise due to the insolvency of the sponsor or a decision by the sponsor to
stop financing benefit provision. For State-sponsored provision the latter is the more
likely reason for discontinuance.

The benefits that will be paid to the members of the discontinued scheme will be affected
by the following factors:

 The rights of the beneficiaries, which will depend on the terms under which the
scheme operates and any overriding legislation.

 The expectations of the beneficiaries, which are likely to be the benefits that would
have been available had the scheme not discontinued.

If there are insufficient assets to meet the rights and expectations of beneficiaries then a
lower benefit will be paid.

If the benefits are to be reduced, legislation or scheme rules may indicate which types of
benefits are to be reduced or which types of beneficiaries are to have their benefits
reduced.

The assets for these purposes may simply be those that have been funded. Alternatively,
there may be additional assets available to secure the discontinuance benefits. Legislation
or ethics may lead to extra funds being made available by a non-insolvent sponsor.
Legislation may require a debt to be placed on an insolvent sponsor, which may rank
alongside, above, or below other debtors. Insurance may have been taken out that ensures
the sufficiency of assets in the event of the insolvency of the sponsor.

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2016 Insolvency and closure Subject CA1

The expenses involved in determining the benefit allocations, informing the beneficiaries
and securing the appropriate form of provision will however reduce the assets.

If assets are more than sufficient to meet the benefit rights under the chosen method of
provision, the surplus may pass back to the sponsor. Alternatively, legislation or scheme
rules may require the surplus funds to be used to increase the benefits. The allocation of
any surplus to individual beneficiaries may also be done taking account of the length of
membership or other possible indicators of the extent to which the individuals can be
viewed to have contributed to the surplus.

2.2 Provision of benefits

If a benefit scheme is being discontinued, the following options may exist for the
provision of the outstanding benefit payments:

 Continuation of the scheme without any further accrual of benefits.

 Transfer of the liabilities to another scheme with the same sponsor.

 Transfer of the funds to the beneficiary to extinguish the liability. Legislation may not
allow an individual to receive the capital value of their benefits. However, an
alternative may exist that allows the individual to place the funds with an appropriate
insurance company or in the scheme of any new employer.

 Transfer of the funds to an insurance company to invest and provide a benefit.

Where benefits are transferred to a third party such as another scheme or an insurance
company, the ultimate benefit will then depend on the future experience of that individual
and the assumptions used to capitalise the benefits. The benefits may therefore be greater
or smaller than the discontinuance benefit.

An alternative may be to transfer of the liabilities to a provider who will guarantee to pay a
specified level of the benefits. The provider will then accept the risks of future experience.
However, there will be risks for the provider in guaranteeing the benefits, for which they
will charge a premium. As a result the balance of the funds may not be sufficient to
provide the benefits that could have been targeted using one of the other forms of
provision described above.

END

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2016 Options and guarantees Subject CA1

UNIT 24 — OPTIONS AND GUARANTEES

Syllabus objective

8.8 Discuss the issues surrounding the management of options and guarantees.

1 Management of options and guarantees

Financial products and schemes often contain terms and features that provide options to
the client with respect to the payment of premiums, benefits, use of the contract proceeds,
or other items.

Insurance contracts frequently contain guarantees beyond the commitment to provide

contractual benefits at the time an insured event arises. For example, the guaranteed
minimum value of a conventional whole life insurance policy may give the policyholder
the option to stop paying premiums and to take the policy value in cash, with a guarantee
that the cash value will never be less than an amount promised in the contract. A more
complex guarantee might be where a contract’s value depends on the growth in a specified
equity index (such as the FTSE 100) with a guaranteed minimum growth rate.

Options will move in and out of the money over time depending on market conditions. It
could be assumed that the holder of an option will always exercise an in the money option
and will never exercise an out of the money option. However, this may not always be the
case and many options are significantly dependent on the option holder’s behaviour in the
sense that some option holders may fail to exercise an in the money option and others may
exercise an out of the money option.

Guarantees may become more or less onerous on the provider over time depending on how
experience develops over time.

Contract values are highly sensitive to option pricing methods and assumptions. The
assumptions used will depend on, among other things:

 the state of the economy, and hence must be scenario specific

 demographic factors such as age, health, employment status
 cultural bias
 consumer sophistication

These sensitivities may change over one time, for example, as consumers become more
aware of options and improve their ability to evaluate the relative merits of electing
options.

The value of guarantees and their influences on consumer behaviour will vary widely
according to the economic scenarios and the sophistication of the market.

Options and guarantees are not independent. Some guarantees may make options more
valuable in certain scenarios. The option holder’s behaviour may be influenced by the

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Subject CA1 Options and guarantees 2016

option that is immediately financially advantageous, rather than an option that may be of
greater value, but where the benefit is realised in the future. A guaranteed annuity rate to
convert the proceeds of a pension fund to an annuity may be significantly in the money.
However the experience is that policyholders who have the option to take part of their
pension fund in cash at retirement, will select this option, rather than the more
advantageous approach of taking the guaranteed rate applied to the full pension fund. The
policyholder perceives immediate cash to be better value than a higher long-term pension.

Risk management techniques can be used to protect the provider against the possible
adverse effects of options and guarantees given in contracts.

Liability hedging can be used to manage options and guarantees. Liability hedging
involves choosing assets in such a way as to perform in the same way as the liabilities. A
specific example of this is immunisation, where assets are matched to liabilities by term in
order to hedge interest rate risk.

An example is when the value of liabilities is linked to some external index (for example,
“guaranteed” contracts where the movement of market indices determines the value of the
contract in some way). In order to hedge such liabilities, use is often made of over-the-
counter derivatives purchased from an investment bank, thereby avoiding the uncertainty
and expense of “rolling-over” short term exchange traded derivatives over the lifetime of
the underlying contract.

Option pricing methods can be used to hedge guarantees and options dynamically.
However, the theoretical possibilities given by models may not always be valid as suitable
tradable assets do not always exist in practice.

Example

XYZ plc is a holding company with diverse business interests and many employees.
Recent legislation has been introduced by the State, which is intended to outlaw
discrimination in the provision of pension benefits. Through its subsidiaries, XYZ plc
operates many different defined benefit and defined contribution pension schemes. As a
result of the new legislation, XYZ plc has amended the design of its defined benefit
schemes so that all options are priced on a unisex basis. At the following valuation of one
of the schemes, a large deficit is revealed.

(i) Outline the possible effects on the scheme’s funding levels of the change in option
pricing to a unisex basis.

(ii) Discuss the other possible sources of surplus or deficit that may have arisen since
the last valuation.

Solution

(i) 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

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2016 Options and guarantees Subject CA1

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) 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
 including 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

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Subject CA1 Options and guarantees 2016

Example

An occupational pension scheme provides members with a retirement pension for life.
There is an option for members to exchange part of their pension for a pension payable to
a chosen dependant. The dependant’s pension will be payable from the death after
retirement of the member, for the remainder of the life of the dependant.

(i) Discuss the factors an actuary needs to consider to assess the appropriate terms for
the exchange.

(ii) State the restrictions the actuary might recommend apply to the exercise of the
option to exchange.

Solution

(i) The scheme documentation may require certain terms to be applied. There may be
legislative requirements, existing industry or insurance custom and practice or
competitive pressures which influence the terms.

The exercise of the option should be financially neutral to the scheme. The actuary
will need to consider an appropriate interest rate to value the benefits, for example
the returns from an appropriate current medium to long term bond. If the intention
is to have a stable conversion basis, an average rate, or the valuation rate could be
used. In this case the basis needs to be reviewed periodically.

A mortality assumption will need to be set based on a mortality table appropriate to

those likely to exercise the option. It could be assumed that the member will select
against the scheme and that the option will only be exercised by those in poor health
and/or those with dependants in good health. If most members with dependants
exercise the option, no special allowance for mortality will need to be made.

The factors should vary according to the age of the member and the dependant. An
average age difference could be assumed with an adjustment to the factor if the
actual age difference is significantly different.

Consideration should be given to whether the terms should take account of

discretionary increases in payment.

Allowance could be made for additional administration costs.

A pragmatic solution to the above points will be needed to ensure that option is easy
to administer, and can be understood by members.

(ii) The restrictions the actuary might recommend should apply to the exercise of the
option to exchange include:

 a limit on the proportion of pension that can be surrendered

 to require evidence of the member’s good health

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2016 Options and guarantees Subject CA1

 restrict exercise of the option to specified times, e.g. just before retirement, at
time of marriage

 once elected, the decision should be irrevocable

 restrict the eligibility to surrender pension according to the nature of the

relationship between the member and the dependant

 the factors should be amended where there is a large difference between the ages
of the member and the dependant

END

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2016 Monitoring Subject CA1

UNIT 25 — MONITORING
Syllabus objectives

9.1 Describe how the actual experience can be monitored and assessed, in terms of:

 the reasons for monitoring experience

 the data required
 the process of analysis of the various factors affecting the experience
 the use of the results to revise models and assumptions

9.2 Describe how the results of the monitoring process in the Actuarial Control Cycle or
the Risk Management Control Cycle are used to update the financial planning in a
subsequent period.

1 Reasons for monitoring experience

Monitoring the experience is a fundamental part of the actuarial control cycle.

The actual experience of a provider should be monitored to check whether the method and
assumptions adopted for financing the benefits continue to be appropriate and, if not, what
changes should be made in order to achieve the desired level of profit.

The experience will be monitored so as to:

 update assumptions as to future experience

 monitor any adverse trends in experience so as to take corrective actions
 provide management information

2 Data required
The basic requirement is that there is a reasonable volume of stable, consistent data, from
which future experience and trends can be deduced.

The data ideally needs to be divided into sufficiently homogeneous risk groups, according
to the relevant risk factors. However, this ideal has to be balanced against the danger of
creating data cells that have too little data in them to be credible. For example for benefit
schemes with a small number of members, it may not be appropriate to carry out any
analysis or at least the results should be recognised as being very crude. This may also be
true when events are infrequent and volatile. For example, a benefit scheme with only
young members may have many members but few deaths in service and so an analysis of
the proportion of deaths may lack credibility.

In practice the level of detail in the classification of the data depends upon the volumes of
data available. The volume of data will not only indicate whether or not an analysis will
produce meaningful results, but it will also indicate the extent to which data can be

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Subject CA1 Monitoring 2016

subdivided without leading to similar problems. For example, it may be necessary to

group data on deaths into, say; five-year age bands rather than single year bands.

As well as data on the feature being assessed, it is necessary to have data on the exposed to
risk, divided into the same cell structure as the experience data. An analysis of experience
is not valid unless experience and exposed to risk are matched.

3 Analysis process
Once the data have been grouped in an appropriate manner, the analysis can be performed.

For statistical factors, such as mortality and withdrawal, this will involve the calculation
for each age band of the number of deaths (or withdrawals) divided by the number
exposed to risk of death (or withdrawal). The results can then be compared with the
assumptions adopted to determine whether there is a significant difference and also with
other relevant standard tables to determine if they appear to be more appropriate to the
scheme.

Economic factors usually have the greatest significance on the result for a company or
scheme, but are also in general outside the management’s control. The main economic
factors for a benefits scheme or insurance company are interest rates and the investment
returns of various sectors. For these the analysis is simply a comparison between the
actual returns and those assumed. The effect of the difference between actual and
expected can be calculated by re-running the expected experience model using the actual
economic experience items.

Example

Describe how a scheme providing benefits based on salary at retirement would analyse the
salary growth of its members over a three year period.

Solution

The analysis will involve dividing the current levels of salary by those that applied for the
same individuals at the previous recording date. However, in many cases salary is not just
time dependent but is also related to age or period of employment. It might be appropriate
to perform an analysis of total salaries for age groups, or alternatively group cells by date
of joining service. This could be performed by the production of a table along the
following lines (assuming analysis by age is chosen and that there is a three-year period
between valuations):

In column (1), age x nearest at this date.

In column (2), salaries at previous recording date (assume here this is three years ago) for
members now age x (represents members aged (x  3) last time).
In column (3), salaries at this recording date for members age x.

In column (4), (3)/(2) is the increase in salary in the three-year period for (x  3) to x.

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Any stable pattern of differences between the figures in this column at different ages may
then indicate the existence of a correlation between salary growth and age. In order to
investigate whether this age related salary growth is consistent with the assumptions
adopted or other possible tables for such growth, the following extra columns could be
added to the analysis table:

In column (5), sx / sx3 (where sx is an assumed salary inflation scale, including general
inflation rises as well as promotional/age-related rises).

In column (6), (4)/(5) as the Actual/Expected.

If the experience had followed the assumptions, then the figures in column (6) will all be
1.000. Any differences will be explained by both general salary increases and
promotional/age-related increases.

To analyse promotional and age-related increases separately, the actuary needs to identify
the global cost of living increases that have been awarded over the last three years, and use
these figures in column (5) with the assumed promotional salary scale. (That is, rework sx
for all ages allowing for actual cost of living increases and the assumed promotional
scale.)

On reworking column (6) the differences from 1 will represent deviations in the
promotional scale alone for ages (x  3) to x over the three year period. This analysis will
also provide us with information on an assumed general salary increase against actual
“cost of living” increases awarded.

3.1 Use of the results

The results of an analysis of experience should not be used blindly. Consideration should
be given to whether the period under investigation was typical and whether the experience
is likely to be representative of future experience. For example, the period under
investigation may have been affected by abnormal events or by significant random
fluctuations — many elements of experience are affected by economic cycles. It is also
possible that there is a gradual change in the experience from period to period, as has been
the case in the past with mortality rates. Before adopting the results of the investigation, it
is therefore necessary to consider the changes over time and whether there is any reason
why any past trends may continue into the future.

If it had not been possible to split the analysis into sufficiently homogeneous groups, it is
important to consider whether the individuals to whom the investigation related are
relatively homogeneous with the individuals whose benefits will be affected by future
experience.

Subject to these considerations the results of the analysis may be adopted as assumptions
when calculating values. However, depending upon the purpose of the assumptions, it
may first be appropriate to make an adjustment in these assumptions to create a margin for
prudence. This may allow for any uncertainty as to the validity of the results of the
analysis.

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4 Using the results of the monitoring process

Monitoring of experience is fundamental to effective implementation of the actuarial
control cycle or the risk management control cycle. The environment in which a provider
operates is constantly changing and monitoring the effect of past actions can help in
revising its strategy for risk management and in reassessing the risks that it faces.

The actuary will use the results of analysing the experience and the surplus arising to
reassess his or her view of the future with regard to the provider. This may result in
changes to the assumptions or models used for pricing or setting contributions or
provisions.

In essence, this is an iterative process. The actuary is trying to estimate how the provider
will progress in the future, based on what has happened in the past. As time goes by, the
actuary will have more information. The assumptions and models resulting from this
should get closer to what will actually happen. The actuary, however, cannot exactly
predict the future.

Example

A life insurance company launched a conventional without profits critical illness term
assurance contract ten years ago. The volume of new business sold has risen significantly
in the last three years. Under the contract no benefit is payable on death or lapse. The
company is about to review the profitability of the contract.

(i) Describe how the company might analyse its critical illness claims experience since
launch.

(ii) Describe how the company might use the results of this analysis to set assumptions
for calculating the profitability of the contract.

(iii) Describe why the results of this analysis may not be indicative of future experience.

Solution

(i) The company will seek to compare the claim rates it has experienced with those
assumed when the contract was designed, or with those in the current supervisory
valuation basis. The basic calculation is to divide the number of claims by the
matching exposed to risk.

The extent of the analysis will depend on the volume of business written. The aim
will be to split the data into homogeneous groups while keeping the volume of data
within each group credible.

Experience should be looked at net and gross of reinsurance.

It is important to be clear about the definition of the exposed to risk for the
denominator of the ratio. Normally this will be the average of the in-force policies
at the year start and the year end (but more accurately if the data is available).

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Normally critical illness claims will be given a full year’s exposure (rather than a
half) in the year of claim.

The analysis would be performed to cover the experience for each year since
commencement. Since significant volumes have only been sold for the last 3 years,
it may be necessary to group the experience for some calendar years together.

Only business accepted at standard rates should be included.

The most important levels at which to carry out the investigation are:

 sex

 age (grouped as required)

 smoker status

 duration since outset (grouped for longer durations) (experience will be lighter
at early durations due to underwriting)

 sales channel (this is an indicator of target market)

If enough data exists then the investigation could also be split by:

 type of illness
 medical / non-medical cases
 occupation
 premium size
 premium payment method

As there may be a delay between the date of claim and when it is admitted, care
needs to be taken to include the claim within the calendar year and duration to which
it relates. Allowance should be made for any incurred but not reported (IBNR)
claims in the more recent years.

(ii) The company might use the results of this analysis to set assumptions for calculating
the profitability of the contract as follows.

Assumptions are required for both the current level of critical illness experience and
the expected future changes in this over the duration of the contract.

In interpreting the experience, care needs to be taken to allow for any features that
may have impacted on the experience over the period of the investigation that may
make it an unreliable guide for the future. The more recent years’ experience would
be used to help make an assumption about the current level of critical illness
experience. This would be expressed as a percentage of reinsurer’s rates, of a
standard table if one exists, or of the pricing basis if different.

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The trend in experience for recent years would be used to help make an assumption
about the expected future trend in critical illness experience. If the volume of data
were sufficient this trend would be considered separately for each type of illness to
understand better the causes of the experience.

(iii) The results of this analysis may not be indicative of future experience for the
following reasons:

 Underwriting standards may have changed over the period of the investigation.

 The experience for durations greater than three is based on small volumes of
data so may not be credible.

 Similarly the trend in the experience is only based on significant volumes of

data for the last 3 years. This is unlikely to be sufficient to give an indication of
likely future trends.

 Changes in the sales process or the target market over the period of the
investigation may affect the experience.

 The average premium size may have changed over the period of the
investigation. This will affect the results if the analysis is not split by premium
size.

 Reductions in premium rates over the period of investigation may have led to
selective lapses and worse experience. If this will not be a feature of the
marketplace in future then the results will not give an appropriate assumption

 Changes in the definition of a critical illness or the critical illness covered over
the period of the investigation will distort results.

 Claims admittance standards may have changed over the period of investigation.

 Future medical advances may lead to earlier detection of critical illnesses or

more routine operations in future such that past trends are not indicative of the
future.

 Consumer pressure may lead to more pressure in future to admit claims that do
not meet the strict definition.

 Past trends in experience may have been caused by particular medical advances
that are not expected to continue in future.

END

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UNIT 26 — PRINCIPAL TERMS

Syllabus objective

10 Have an understanding of the principal terms used in financial services and risk
management.

Introduction
In financial services many terms vary by company, class of business, market and country. An
important part of any actuarial investigation is to verify the exact meaning of any important terms
used. This unit gives the definitions mainly used in practice.

A potential source of confusion is the term used to denote the value assigned to the liabilities. It has
been the practice of accountants to use the word “provision” to denote the value of a liability that is
known or assumed to exist at the accounting date, and to confine the term “reserve” to any amount,
over and above the provisions, that is available to meet additional liabilities, either in respect of future
events or in respect of past events for which the provisions may prove to be inadequate. However,
among insurers, and also among actuaries, there has been a long established practice of applying the
term “reserve” to both categories.

In the European Union, following the adoption of the Insurance Accounts Directive and its enactment
in the legislation of each of the Member States, it has become the practice to distinguish between
provisions and reserves in insurance companies’ shareholders’ accounts and also in the accounts that
form part of the statutory returns to the insurance supervisory authorities. However, in North America
and to some extent in the Lloyd's market, the practice of applying the term “reserve” to both
categories continues. It seems likely that among actuaries and others the habit of using the term
“reserves” for what are often called provisions will persist for some time even in the UK,
notwithstanding the legislative changes.

The terms marked with * are taken from or adapted from the PMI/PRAG publication “Pensions
Terminology”.

Accrual rate*
The rate at which rights build up for each year of service in a defined benefit scheme.

Accrued benefits*
The benefits for service up to a given point in time, whether vested rights or not. They may be
calculated in relation to current earnings or projected earnings. (Allowance may also be made for
revaluation and/or pension increases required by the scheme rules or legislation.)

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Accumulation of risk
An accumulation of risk occurs when a portfolio of business contains a concentration of risks that
might give rise to exceptionally large losses from a single event. Such an accumulation might occur
by location (property insurance) or occupation (employers’ liability insurance), for example.

Acquisition costs
Costs arising from the writing of insurance contracts including:

 direct costs, such as acquisition commission or the cost of drawing up the insurance document or
including the insurance contract in the portfolio

 indirect costs, such as advertising costs or the actuary’s/underwriter’s expenses connected with
the establishment of the premium rating table

Active member*
A member of a benefit scheme who is at present accruing benefits under that scheme in respect of
current service.

All risks
A term used where the cover is not restricted to specific perils such as fire, storm, flood etc. The
cover is for loss, destruction or damage by any peril not specifically excluded. The exclusions will
often be inevitabilities such as wear and tear. The term is sometimes loosely used to describe a policy
that covers a number of specified risks, though not all.

Anti-selection
People will be more likely to take out contracts when they believe their risk is higher than the
insurance company has allowed for in its premiums. This is known as anti-selection.

Anti-selection can also arise where existing policyholders have the opportunity of exercising a
guarantee or an option. Those who have most to gain from the guarantee or option will be the most
likely to exercise it.

Arbitrage
The simultaneous buying and selling of two economically equivalent but differentially priced
portfolios so as to make a risk free profit.

Average earnings scheme*

A benefits scheme where the benefit for each year of membership is related to the pensionable
earnings for that year. Such schemes are alternatively referred to as career average schemes.

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Balance of cost scheme

A defined benefits scheme to which beneficiaries make a defined contribution and the main sponsor
pays the remainder of the unknown cost of providing the benefits.

Bear market
A period of time during which investors are generally unconfident and stock market prices decline.
(Compare with bull market.)

Benchmark
A standard or model portfolio against which a fund’s structure and performance will be assessed.

Best estimate
An actuarial assumption which the actuary believes has an equal probability of under- or over- stating
the future experience (i.e. the median of the distribution of future experience.)

Bid (also selling) price

The price at which a market maker offers to buy a security. The price at which the manager of a
unitised financial product is prepared to buy back units from an investor.

Break-up basis
A valuation basis that assumes that the writing of new business ceases and cover on current policies is
terminated. In relation to general insurance policies, current policyholders would normally be entitled
to a proportionate return of the original gross premium. Deferred acquisition costs would probably
have to be written off. Also known as a wind-up basis.

Bond

A bond is a form of loan. The holder of a bond will receive a lump sum of specified amount at some
specified future time together with a series of regular level interest payments until the repayment (or
redemption) of the lump sum.

Book reserve
A provision in a company’s accounts for a future benefit liability for which no funds have been set
aside.

Bulk transfer
The transfer of liabilities (and usually assets), relating to a group of members, from one benefit
scheme to another.

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Subject CA1 Principal terms 2016

Bull market
A period of time during which investors are generally confident and stock market prices increase.
(Compare with bear market.)

Call option
The right, but not the obligation, to buy a specified asset on a set date in the future for a specified
price. (Compare with put option.)

Cancellation
A mid-term cessation of a general insurance policy that may involve a partial return of premium.

Cap
An upper limit. For example, on a benefit, a contribution, benefit growth or a funding level.

Catastrophe
A catastrophe is a single event that gives rise to exceptionally large losses. The exact definition often
varies and is often dependent on excess of loss wordings: e.g. it might mean all losses incurred in a 72
hour period from a single event such as a wind storm.

Catastrophe reserve
A reserve built up over periods between catastrophes to provide some contingency against the risk of
catastrophe.

Ceding company (cedant)

An insurance or reinsurance company that passes (or cedes) a risk to a reinsurer. The term “cedant”
may also be applied to a Lloyd’s syndicate.

Chinese walls
Regulations or practices intended to prevent conflicts of interest in integrated security or consultancy
firms.

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Claim
The most common meanings are:

 as a noun: an assertion by a policyholder that an insurer is liable to make a payment in accordance

with the terms of a policy

 as a verb: to make a request for payment from an insurer

Care is often needed to discover the precise meaning in a given context — e.g. whether a reference to
“claims” is to the number of claims or their cost.

Claim frequency
The number of claims in a period per unit of exposure, such as the number of claims per vehicle year
for a calendar year or per policy over a period.

Closed scheme*
A benefits scheme which does not admit new members. (Contributions may or may not continue and
benefits may or may not be provided for future service.) Similarly insurers can be closed to new
business, or have closed funds.

Coinsurance
An arrangement whereby two or more insurers enter into a single contract with the insured to cover a
risk in agreed proportions at a specified premium. Each insurer is liable only for its own proportion of
the total risk.

Commission
Commission refers to the payments made by a provider to reward those who sell and subsequently
service its products, whether they be independent financial intermediaries, tied agents or a direct
salesforce. Typically the amount of the commission depends on the type and size of contract.

Commutation*
The giving up of a part or all of a stream of future income for an immediate lump sum.

Composite insurer
An insurance company writing both life and non-life business.

Continuing Care
Nursing or medical care provided after retirement.

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Continuing Care Retirement Community

A development in which retired persons can live as a community and received chosen levels of
nursing or medical care.

Convexity
The convexity of a bond is defined as

1 d 2P
C= ,
P di 2

where P is the dirty price of the bond and i is the gross redemption yield on the bond.

Corporate Governance*
The system whereby boards of directors are responsible for the governance of their companies upon
appointment by shareholders, who ensure that an appropriate governance structure is in place.

Corporation tax
Tax on company profits.

Counterparty
The opposite side in a financial transaction.

Coupon
The interest payments on a bond.

Covenant
An agreement that is legal and binding on the parties involved. The expression is often used in
association with corporate debt, because the borrower is bound to the terms of the agreement. The
expression is also used in property investment because the tenant or lessee is bound to the terms of the
lease agreement. In fact the meaning of covenant has been extended in the context of property
investment so that it usually refers to the quality of the tenant, e.g. a tenant with a good covenant is a
good quality tenant who is unlikely to break the terms of the agreement.

Credibility
A measure of the weight to be given to a statistic. This often refers to the experience for a particular
risk (or risk group) compared to that derived from the overall experience of a corresponding parent or
larger population. The measure is used to determine a premium when using experience rating.

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Credit rating
A rating given to a company’s debt by a credit-rating company as an indication of the likelihood of
default. Top rating is usually AAA. Credit ratings are much used.

Credit risk
The risk that the counterparty to an agreement will be unable or unwilling to make the payments
required under the agreement.

Custodian
The keeper of security certificates and other assets on behalf of investors.

Debenture
A loan made to a company which is secured against the assets of the company. Debentures usually
have a floating charge over the assets of the company so that debenture holders rank above other
creditors should the company be wound up. Debentures with fixed charges are called mortgage
debentures.

Deferred member
A member of a benefits scheme who is no longer accruing benefits but who has accrued benefits that
will be payable at a future date.

Deficit (or underfunding)

Where a benefits scheme or financial product provider has less assets than required by the funding
plan to meet the liabilities.

Defined ambition scheme

A scheme where risks are shared between the different parties involved, for example scheme
members, employers, insurers and investment businesses.

Defined benefit scheme*

A benefits scheme where the scheme rules define the benefits independently of the contributions
payable, and benefits are not directly related to the investments of the scheme. The scheme may be
funded or unfunded.

Defined contribution scheme

A scheme providing benefits where the amount of an individual member’s benefits depends on the
contributions paid into the scheme in respect of that member increased by the investment return
earned on those contributions.

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Depreciation
An accounting convention whereby firms write down the value of their assets over time.

Derivative instrument
A financial instrument with a value dependent on the value of some other, underlying asset.

Discontinuance valuation*
An actuarial valuation carried out to assess the position if a benefits scheme were to be discontinued.
The valuation may take into account the possible exercise of any discretion to augment benefits.

Discounted income model

A model for valuing investment which determines a present value for the investments by discounting
the expected future income from the assets.

Dividend yield
The running yield (dividends  share price) on an equity.

Duration
The duration of a conventional bond (also known as the effective mean term or discounted mean
term) is the mean term of the payments from the stock, where each term is weighted by the present
value of that payment. In general:

 PV  t
Duration =
 PV

where t is measured in years and PV is the present value of the payment at time t calculated at the
gross redemption yield. Duration is closely related to volatility.

Early leaver*
A person who ceases to be an active member of a benefit scheme, other than on death, without being
granted an immediate retirement benefit.

Economic value added

The percentage difference between the annual return on capital and the weighted average cost of
capital.

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Efficient frontier
An efficient portfolio is one for which it is not possible to increase the expected return without
accepting more risk and not possible to reduce the risk without accepting a lower return. The efficient
frontier is the line joining all efficient portfolios in risk-return space. In portfolio theory, risk is
defined as variance or standard deviation of return.

Efficient market hypothesis

A hypothesis that asset prices reflect all relevant information.

Embedded value
It represents the value to shareholders of the future profit stream from a company’s existing business
together with the value of any net assets separately attributable to shareholders.

Emerging market
Stock markets in developing countries such as China, Mexico, Singapore etc. They offer high
expected returns due to rapid industrialisation. They are also very risky markets.

Equity
(1) Ordinary shares issued by a company as a share in the equity capital of a company. In effect the
equity holders are the owners of the company. Ordinary shareholders have the right to receive
all distributable profits of the company after debt holders and preference shareholders have been
paid. They also have the right to attend and vote at general meetings of the company.

(2) This is a term that is difficult to define. In essence, it means that all policyholders are treated
fairly. That is that some groups of policyholders do not benefit at the expense of other groups.
In a proprietary company, equity also needs to be considered between policyholders and
shareholders. Questions of equity arise in the distribution of surplus, in the determination of
variable charges and in the determination of surrender values and alteration terms.

Excess
The sum, specified in the policy, that the insured must bear before any liability falls upon the insurer.
The insured pays the first £E of every claim, where £E is the excess.

Excesses are widely used in personal lines of insurance such as motor insurance. They may be
compulsory, in that they apply to all claims of the types specified, or voluntary to secure lower
premiums.

Exclusion
An event, peril or cause defined within the policy document as being beyond the scope of the
insurance cover.

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Experience rating
A system by which the premium of each individual risk depends, at least in part, on the actual claims
experience of that risk (usually in an earlier period, but sometimes in the period covered).

Exposure
This term can be used in three senses:

 the state of being subject to the possibility of loss

 a measure of extent of risk
 the possibility of loss to insured property caused by its surroundings

Extra premium
An extra premium is an addition to the standard premium payable under a contract in order to cover
an extra risk.

Extra risk
An extra risk arises where a proposal for life insurance is not acceptable at standard rates.

Final salary scheme*

A defined benefit scheme where the benefit is calculated by reference to the final earnings of the
member, and usually also based on pensionable service.

Financial gearing
The expression “gearing” or “financial gearing” is often used to refer to the impact on the profits for a
company caused by fixed interest borrowing. For a financially highly geared company a small change
in the total profits might have a very large proportionate impact on the profits for shareholders. A
company with lots of fixed interest borrowing is “highly geared”.

Financial strength
This usually refers to the ability of a life insurance company:

 to withstand adverse changes in experience, including those arising from investment in higher
yielding but more volatile assets

 to fulfill its new business plans

 to meet the reasonable expectations of its policyholders

and is often measured by the level of its free assets.

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Flexible benefits
Benefit provision under which the beneficiary has choice about the types or levels of benefits to be
received. Will usually involve an option to receive salary instead of other forms of benefits.

Floor
A lower limit. For example on a benefit, a contribution, benefit growth or a funding level.

Free assets
This term is loosely used to refer to that part of a life insurance company’s assets that are not needed
to cover its liabilities. Opinion differs as to what should be included in the liabilities.

For example, in the UK the term is often used to describe the excess of the value of the assets over the
value of the liabilities as reported for supervisory purposes.

Freehold
The freeholder of land is the absolute owner of it in perpetuity.

Funding objective
The arrangement of the incidence over time of payments with the aim of meeting the future cost of a
given set of benefits.

Futures contract
Like a forward contract, this is a contract to buy (or sell) an asset on an agreed basis in the future.
However, futures contracts are standardised contracts that can be traded on a recognised exchange.

Gearing
The ratio of debt to equity. Often referred to as financial gearing.

Gilt
A bond issued by the British Government that pays regular coupons.

Going-concern basis
The accounting basis normally required for an insurer’s published accounts, that is based on the
assumption that the insurer will continue to trade as normal for the long term future.

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Group contract
This is a contract that covers a group of lives, where the group is specified but not necessarily the
individuals within it.

Guarantee (investment)
In the context of life insurance, this refers to a promise that the company will pay a specified sum of
money — or sums of money — at specified times if a specified condition is fulfilled. The condition
can be an event such as the surrender or maturity of a contract.

The term can also refer to the situation where a company guarantees the rate it will use, at some future
date, to convert a lump sum into an annuity or vice versa.

Hedging
Action taken to protect the value of a portfolio against a change in market prices. Hedging involves
holding offsetting positions in assets or portfolios the values of which are expected to respond
identically to market changes.

Hurdle rate
A target or minimum rate of return used in Capital Project assessment.

Immunisation
Ensuring that the discounted mean term of assets equals that of the liabilities and that the spread of the
assets is greater than the spread of the liabilities. This means that a uniform change in interest rates
will cause the reinvestment rate and capital value on assets to move in opposite directions so that a
fund does not make a loss.

Indemnity, principle of
The principle whereby the insured is restored to the same financial position after a loss as before the
loss. This is typical of most types of insurance. This contrasts with the new-for-old basis of
settlement, often used in home contents insurance, under which the insured is entitled to the full
replacement value of the property without any deduction for depreciation or wear and tear.

Index-linked gilt
A bond issued by the British Government for which the interest payments and the final redemption
proceeds are linked to movements in the RPI.

Index-linked security
A security whose redemption value and / or coupon payments are adjusted to reflect inflation.

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Index tracking
An index tracking fund (or an “index fund”) is an investment fund with the specific objective of
tracking a particular index. The fund manager can either hold all the stocks in the index in the
appropriate proportions (known as “full replication”) or use some mathematical model to choose a
smaller sample of stocks which will perform as closely as possible to the index.

Inflation risk premium

The difference between the yield on a fixed income bond and the sum of the guaranteed real yield and
the expected inflation rate on a similar index-linked bond. It is required as compensation for the
uncertainty in the real return on the bond by investors with index-linked liabilities. Under the
inflation risk premium theory the yield curve will tend to slope upwards because investors need a
higher yield to compensate them for holding longer dated stocks which are more vulnerable to
inflation risk than shorter dated stocks.

Insured scheme*
A benefit scheme where the sole long term investment medium is an insurance policy (other than a
managed fund policy).

Internal rate of return

The discount rate at which the Net Present Value of a series of cash flows is zero.

Investment trust
Investment trusts are public companies whose function is to manage shares and investments. They
have a capital structure in the same way as other public companies and can raise both loan and equity
capital. Most have quoted shares allowing small investors to gain exposure to the portfolio held by
the investment trust.

Lapse
A life insurance contract lapses if the policyholder ceases to pay premiums. In some cases a more
specific definition is used: the policyholder withdraws without the company making a payment —
surrender value — to him or her.

Leasehold
A lease is an agreement which allows one of the parties (the leaseholder) the use of a specified portion
of a building owned (or sometimes itself leased) by the other party for a specified period in return for
some payment (the rent).

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Subject CA1 Principal terms 2016

Liquidity preference
The liquidity preference theory is based on the generally accepted belief that investors prefer liquid
assets to illiquid ones. Investors require a greater return to encourage them to commit funds for a
longer period. Long dated stocks are less liquid than short dated stocks, so yields should be higher for
long dated stocks.

Long
A long position in an asset means having an economic exposure to the asset. In futures and forward
dealing the long party is the one who has contracted to take delivery of the asset in the future.
(Compare short.)

Long-tailed business
Types of insurance in which a substantial proportion (by number or amount) of claims take several
years to be notified and/or settled from the date of exposure and/or occurrence.

Loss
(1) The financial loss suffered by a policyholder, as distinct from the amount of any insurance claim
that may be payable in respect of that financial loss.

(2) The amount of the insurance claim, as in the expression “loss reserve” which means the same as
the reserve (or provision) for outstanding claims.

(3) In relation to accounts, the opposite of “profit”. In this case, the word needs to be appropriately
qualified, e.g. underwriting loss or operating loss.

Managed fund*
(1) An investment contract by means of which an insurance company offers participation in one or
more pooled funds.

(2) An arrangement where the assets are invested on similar lines to unit trusts by an external
investment manager.

Market capitalisation
The total value at market prices of the securities at issue for a company, or a stock market, or a sector
of a stock market.

Market risk
Market risk is the risk relating to changes in the value of a portfolio due to movements in the market
value of the assets held.

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Market value of assets

The market value of assets represents what they are worth in the open market, given a willing buyer
and a willing seller.

Matching
Arranging assets and liabilities so that the cash flows generated by the assets can be expected to meet
the liability payouts, either because the assets generate income of the right amount at the right time or
because the market values of the assets are linked to the market values of the liabilities appropriately.

Member*
(1) A person who has been admitted to membership of a pension scheme and is entitled to benefit
under the scheme.

(2) A person who is entitled to participate in the management (usually by having a vote at General
Meetings) of a mutual insurance company or society.

Mismatching reserve
If the assets of an insurance company are not matched to its liabilities, it may be unable to meet
claims as they fall due in the event of adverse future investment conditions. It may be required to set
up a mismatching reserve that it can call upon if experience so requires.

Money purchase*
The determination of an individual member’s benefits by reference to contributions paid into a benefit
scheme in respect of that member, usually increased by an amount based on the investment return on
those contributions.

Moral hazard
The action of a party who behaves differently from the way they would behave if they were fully
exposed to the consequences of that action. The party behaves inappropriately or less carefully than
they would otherwise, leaving the organisation to bear some of the consequences of the action. Moral
hazard is related to information asymmetry, with the party causing the action generally having more
information than the organisation that bears the consequences.

This is not the same as anti-selection which is also taking advantage of particular aspects of an
insurance contract, but within the terms offered by the insurer.

Mutual insurer
A mutual insurer is owned by policyholders to whom all profits (ultimately) belong.

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Net asset value per share

The book value of the shareholders’ interests in a company, usually excluding intangibles such as
goodwill, divided by the number of shares in issue.

New business strain

New business strain arises when the premium(s) paid at the start of a contract, less the initial expenses
including commission payments, is not sufficient to cover the reserve that the company needs to set
up at that point.

Nil claim
A claim that results in no payment by the insurer, because, for example:

 The claim is found not to be valid.

 The amount of the loss turns out to be no greater than the excess.

 The policyholder has reported a claim in order to comply with the conditions of the policy but has
elected to meet the cost in order to preserve any entitlement to no-claim discount.

No-claim discount (NCD)

A form of experience rating in which policyholders are allowed a discount from the basic premium
according to a scale that depends upon the number of years since the most recent claim.

Nominal value
This term refers to an amount of stock. It is the amount specified on the stock certificate. Dealings in
debt securities are carried out in amounts of nominal.

Occupational scheme*
A benefits scheme organised by an employer or on behalf of a group of employers to provide benefits
for or in respect of one or more employees.

Offer (also buying) price

The price at which a market maker offers to sell a security. The price at which the manager of a
unitised financial product is prepared to sell units to an investor.

Open ended investment company (OEIC)

An investment vehicle similar in corporate governance features to an investment trust but with the
open ended characteristics of a unit trust.

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Operational risk
Operational risk is the risk of loss due to fraud or mismanagement within an organisation.

Option
The right to buy or sell an asset.

Option (health)
A health option is where the life insurance company gives a policyholder the right to increase or
extend the death — or sickness — cover under a life insurance contract at some future time or times
without further evidence of health.

Option premium
The price paid for an option. Received by the writer.

Option writer
The seller of an option.

Pay-as-you-go*
An arrangement under which benefits are paid out of revenue and no funding is made for future
liabilities.

Payback period
The time period it takes for an investment to generate sufficient incremental cash to recover its initial
incremental capital outlay in full.

Preference share
A particular class of share which generally ranks ahead of ordinary shares. Preference shareholders
are normally entitled to a specified rate of dividend and, unlike ordinary shareholders, are not entitled
to residual profits. Although part of a company’s share capital, from an investment perspective
preference shares are much more like fixed interest bonds.

Prime
Property that is most attractive to investors is called “prime”. Prime property would score highly on
all of the following factors:

 location

 age and condition

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 quality of tenant

 the number of comparable properties available to determine the rent at rent review and for
valuation purposes

 lease structure

 size

Profit commission
Commission paid by a reinsurer to a cedant under a proportional reinsurance treaty that is dependent
upon the profitability of the total business ceded during each accounting period. Also used in other
arrangements, such as commission contingent on claims experience.

Profit test
A profit test is a technique involving consideration of the cash-flows arising under a contract to assess
the expected profitability of that contract. It can be used to determine the premium or the level of
charges under a contract.

Proprietary insurer
An insurance company owned by shareholders.

Privatisation
The sale of state assets or businesses, often to reduce government debt.

Put option
The right, but not the obligation, to sell a specified asset at a specified price at specified times.
(Compare with call option.)

Rating basis
The collection of assumptions used to associate the risk premium with the characteristics of the risk
being insured.

Rating factor
A factor used to determine the premium rate for a policy, which is measurable in an objective way and
relates to the likelihood and/or severity of the risk. It must, therefore, be a risk factor or a proxy for a
risk factor or risk factors.

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Real yield
The yield on an investment after inflation has been allowed for. Often approximated as the difference
between the nominal yield and the rate of inflation over the corresponding period.

Redemption
The return to an investor of the capital value of a debenture or other debt security. Redemption may
take place on a fixed date or on one of a series of specified dates. The bond may include an option for
the borrower to choose the date or for the lender to choose. The capital amount repaid may be fixed
or linked to an index.

Redemption yield
The gross redemption yield (the word gross is often omitted), or yield to maturity, is the rate of return
at which the discounted value of all future payments of interest and capital is equal to the “dirty” price
of a debt security. The net redemption yield allows for taxation of the amounts received by the
investor.

Reinsurance
An arrangement whereby one party (the reinsurer), in consideration for a premium, agrees to
indemnify another party (the cedant) against part or all of the liability assumed by the cedant under
one or more insurance policies, or under one or more reinsurance contracts.

Reinsurer
An insurer providing reinsurance cover. Some reinsurers do not write any direct or primary insurance
business.

Requirement for capital

On a per contract basis, the requirement for capital is the amount of finance a company needs in order
to be able to write that contract, i.e. the new business strain. This can be extended to the whole
company where its requirement for capital is the finance it needs in order to be able to carry out its
new business plans.

Retention
In the context of reinsurance, a company’s retention is the amount of any particular risk that it wishes
to retain for itself. It will then reinsure the excess over that retention.

Retail price inflation

The measurement of price changes at the retail (consumer) level.

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Return on capital employed (ROCE)

Profit before interest and tax divided by capital employed, expressed as a percentage. An indicator of
a company’s efficiency in generating profit from its asset base.

Risk-based capital (RBC)

The assessment of the capital requirement for an provider by considering the risk profile of the
business written and of any other operations.

Risk discount rate

A risk discount rate is a rate at which future uncertain cash flows might be discounted. It typically
arises when carrying out a discounted cash flow assessment of value of a project. It represents the
risk-free rate of return that the providers of capital demand plus an amount to allow for the risk that
the profits may not emerge as expected from the project.

Risk factor
A factor that is expected, possibly with the support of statistical evidence, to have an influence on the
intensity of risk in an insurance contract.

Risk premium
The amount of premium required to cover claims expected for a risk, i.e. average claim amount 
average claim frequency. It may alternatively be expressed as a rate per unit of exposure.

The additional return required over the risk-free return to reflect the riskiness of future cashflows.

Running yield
The annual income on an investment divided by its current market value. Important examples are the
flat yield on gilts, the gross dividend yield on equities and the rental yield on property.

Run-off basis
A valuation basis that assumes an insurer will cease to write new business, and continue in operation
purely to pay claims for previously written policies. Typically expenses and reinsurance
arrangements change after an insurer ceases to write new business.

Self administered scheme*

An occupational benefits scheme where the assets are invested, other than wholly by payment of
insurance premiums, with an in house investment manager or an external investment manager.

Self-insurance
The retention of risk by an individual or organisation, as distinct from obtaining insurance cover.

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Self investment*
The investment of the assets of an occupational benefits scheme in employer related investments.

Short
A short position in an asset means having a negative economic exposure to the asset. In futures and
forward dealing the short party is the one who has contracted to deliver the asset in the future.
(Compare long.)

Short-tailed business
Types of insurance in which most claims are usually notified and/or settled in a short period from the
date of exposure and/or occurrence.

Solvency
A provider is solvent if its assets are adequate to enable it to meet its liabilities. Supervisory
authorities will usually have requirements, in terms of the values a provider can place on its assets and
liabilities, for the purpose of showing statutory solvency.

Solvency margin
The solvency margin of a provider is the excess of the value of its assets over the value of its
liabilities.

Specific risk
The risk of holding a share which is unique to the industry or company and can be eliminated by
having a suitably diversified portfolio of shares of differing types of companies. This is sometimes
also referred to as alpha, unsystematic, diversifiable or residual risk.

Spot interest rate

The n year spot interest rate is the geometrical average of the interest rates that are expected to apply
over the next n years. It is the redemption yield on an n year zero coupon bond. (See zero coupon
yield curve.)

Surplus
(1) Surplus is the excess of the value placed on a life insurance company’s assets over the value
placed on its liabilities. A negative surplus is usually called a strain.

(2) A type of proportional reinsurance where the Cedant retains the risk up to its retention level and
reinsures the excess.

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Surrender value
This is the amount paid out to a policyholder who terminates his or her contract before the contractual
termination date.

Swap
A contract between two parties under which they agree to exchange a series of payments according to
a pre-arranged formula.

Systematic risk
The risk of the individual share relative to the overall market which cannot be eliminated by
diversification.

Terminal funding
An arrangement whereby a payment to meet the value of a benefit is made only at or about the time
when the benefit is due to commence.

Treasury bill
A short term government debt security. Usually issued with a term of 91 or 182 days. No interest is
paid, but the bill is issued at a discount to its redemption value.

Trust*
A legal concept whereby property is held by one or more persons (the trustees) for the benefit of
others (the beneficiaries) for the purposes specified by the trust instrument. The trustees may also be
beneficiaries.

Trust Deed*
A legal document, executed in the form of a deed, which establishes, regulates or amends a trust.

Trustee*
An individual or company appointed to carry out the purposes of a trust in accordance with the
provisions of the trust instrument and general principles of trust law.

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

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(2) The provision of some form of guarantee. In investment, underwriting is where an institution
gives a guarantee to a company issuing new shares or bonds that it will buy any remaining shares
or bonds that are not bought by other investors.

Underwriting cycle
The process whereby relatively high and thus profitable premium rates that often result in an increase
in the supply of insurance are followed by lower and less profitable premium rates usually associated
with increased competition. These in turn may be followed by a decrease in supply as companies
leave the less profitable market, reduced competition and a return to higher premium rates. This
process is complex but appears to occur in all types of insurance and reinsurance, though at different
speeds and to different degrees.

Underwriting factor
Any factor that is used to determine the premium, terms and conditions for a policy. It may be a
rating factor or some other risk factor that is accounted for in a subjective manner by the underwriter.

Unitised contracts
After deducting an amount to cover part of its costs, each premium under a unitised contract is used to
buy units at their offer price. These units are added to the contract’s unit account. When the insured
event happens the amount of the benefit is then based on the bid price value of all the units in the
contract’s unit account.

Unit trust
An open ended investment vehicle whereby investors can buy “units” in an underlying pool of assets
from the trust manager. If there is demand for units, the managers can create more units for sale to
investors. If there are redemptions (sales by investors), the managers will buy in units offered to
them. Unit trusts are trusts in the legal sense.

Unsecured loan stock

A form of long term corporate debt which is not secured on any specific assets of the borrower.

Valuation rate of interest

The rate at which future liabilities and assets are discounted to the valuation date.

Vested rights
Benefits to which a member of a scheme is entitled whether or not they remain an active member of
the scheme.

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Volatility
The sensitivity of the market price of an investment. A highly volatile investment is one which has a
very unstable price. For fixed interest bonds, volatility is specifically defined as the rate of change in
the dirty price (P) of the bond for a change in the gross redemption yield (y).

1 dP
V=
P dy

Volatility is also known as “modified duration”.

Waiting period
(1) In the case of occupational pension provision, the period during which an employee does not yet
meet the eligibility conditions for membership of the occupational benefits scheme.

(2) In the case of sickness benefits, the period beginning at the policy inception during which the
policyholder is not allowed to make a claim.

Waiver of premium
This is a benefit attached to a contract under which regular premiums are payable. In the event of
sickness or disability or, sometimes, unemployment, the premium payable under the contract,
including the premium for the waiver of premium benefit, is waived.

Weighted average cost of capital

The aggregate return required by the providers of debt and equity capital, allowing for the effects of
tax and the risks borne by the capital providers.

Winding-up*

The process of terminating a benefits scheme, usually by applying the assets to the purchase of
individual insurance contracts for the beneficiaries, or by transferring the assets and liabilities to
another scheme.

Withdrawal benefit
A benefit payable when an employee leaves a benefits scheme.

With profit (participating)

A life insurance contract is with profit if the policyholder is entitled to receive part of the surplus of
the company. The extent of the entitlement is usually at the discretion of the company.

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Without profit (non-participating)

A life insurance contract is without profit if the life insurance company has no discretion over the
amount of benefit payable, i.e. the policy document will specify at outset either the amount of the
benefits under the contract or how they will be calculated.

Yield curve
A plot of yield against term to redemption. Usually the yield plotted is the gross redemption yield on
coupon paying bonds but other yields can be used.

Zero coupon bond

A bond where the sole return is the payment of the nominal value on maturity.

Zero coupon yield curve

A plot of redemption yields against term to redemption for (usually hypothetical) zero coupon bonds.

BASIC CONTRACT TYPES

The sections below provide a general indication and example of the types of contract that the
examiners may describe in examination questions. The examiners will not be testing detailed
knowledge of such contracts but will expect candidates to be able to apply their understanding of
principles to both these basic contract types and to other contracts that may exist independently or
where two or more of these basic contract types are combined together as a package.

Endowment assurances
A pure endowment provides a benefit on survival to a known date and hence operates as a savings
vehicle, for example to provide a lump-sum on retirement, or a means of repaying a loan. An
endowment assurance also provides a significant benefit on the death of the life insured before that
date and, in this case, operates also as a vehicle for providing protection for dependants.

A group endowment assurance would enable, for example, an employer to provide benefits at
retirement, and maybe also on death in service, in respect of his or her employees.

Whole life assurances

A whole life assurance will provide a benefit on the death of the life insured whenever that might
occur. It is hence useful as a means of providing for funeral expenses or for meeting any liability to
tax, for example inheritance tax or death duties, arising on the death of the life insured. It is a general
purpose contract for providing long term protection to dependants.

There would not seem to be a consumer need for a group version of this contract.

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Term assurances
A term assurance provides a benefit on the death of the life assured provided it occurs within the term
selected at outset. As the policy will not pay a benefit in every case (as with endowment and whole
life assurances), the cost is usually considerably cheaper. Term assurances do not normally have any
benefit paid on early termination.

Where an individual takes out the contract, it provides protection against financial loss for the
assured’s dependants

A decreasing term assurance can be used to meet two specific needs. First, it can be used to repay the
balance outstanding under a loan and, secondly, it can be used to provide an income for a family with
children following the death of the income provider until such time as the latter can fend for
themselves.

Where the policyholder is a corporate body or partnership, the contract can be used to provide
protection against the financial loss that might arise on the death of a key person within the
organisation.

The group equivalent of the term assurance contract can be used by an employer to provide a benefit
to dependants on the death, whilst in employment, of an employee.

There are also other uses for a group contract. For example it can also be used by a credit card
company to provide a benefit on death equal to the balance outstanding on a credit card. Any supplier
of goods with payment in instalments could use a term assurance to cover the risk that recovered
goods are less valuable than the outstanding loan balances due on death.

Convertible or renewable term assurance contracts

For individuals, these contracts combine the attractions of a term assurance, in terms of obtaining
cheap death cover, with the certainty of being able either to convert to a permanent form of contract,
i.e. an endowment or whole life assurance, when it can be afforded or to renew the original contract
for a further period of years, all without health evidence being provided (unless the benefit level is
increased).

A comparable group arrangement would be the option for an individual in a scheme covered by a
group life policy to convert to some form of individual arrangement on leaving the scheme.

Immediate annuity contracts

These meet a financial need for an income for the remainder of the life of the insured, for example
after his or her retirement, or for an income during a limited period, for example to pay the school fees
of the insured’s children. Contracts for a limited period are called temporary annuities. A single
premium (or consideration) purchases the income, which commences immediately after purchase.
A group version of the contract can be used by an employer to fund for pensions for his or her
employees at or after retirement.

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Deferred annuity contracts (including personal pensions)

Deferred annuities can be used when there is time between the date of purchase and the date when the
income stream is required to start. The contract can thus be paid for either by a single or regular
premium during the deferred period.

The contract enables individuals to build up a pension that becomes payable on retirement from
gainful employment. At the vesting date of the annuity, an alternative lump sum may be offered in
lieu of part or all of the pension, thereby meeting any need for a cash sum at that point, for example to
pay off a house purchase loan. This is commonly referred to as a “cash option”.

In practice, the same aims can be achieved, in potentially a more flexible way, by combining an
endowment assurance with an immediate annuity starting at the maturity date. The rate at which the
proceeds of the policy in the deferment phase can be converted into an annuity might be guaranteed at
outset, or current market rates might be used.

The group equivalent of a deferred annuity can be used by an employer to fund for pensions for his or
her employees.

Income Protection insurance contracts

The contract enables individuals to provide an income for themselves and their dependants in the
event of the insured risk occurring.

The most common insured risk is long term sickness or incapacity due to accident or illness.

Alternative insured risks could include unemployment, or birth of a handicapped child needing high
levels of care. These contracts typically terminate at retirement age, and do not provide benefits for
the first period of any claim. In the first period of a claim it is assumed that the insured will have
other resources, for example a company sick pay scheme or state benefit provision.

The group equivalent can be used by an employer to provide a sick-pay scheme for employees.

Critical illness contracts

The contract provides a cash sum on the diagnosis of a “critical” illness, such as heart attacks, strokes
or many forms of cancer, which could be used for nursing and other care. It therefore meets an
important need for financial security in the event of contracting such illnesses. In the stand-alone
contract, no benefit is paid on death.

Where the benefit is attached to another contract, typically an endowment, whole life or term
assurance, it usually constitutes an acceleration of the death benefit.

A group version of the stand-alone contract could be used by an employer to provide financial
security for employees in the event of contracting a critical illness.

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Long-term care contracts

The contract can be used to help provide financial security against the risk of needing either home or
nursing-home care as an elderly person, i.e. post-retirement. The contract could pay for all the costs
of care throughout the remainder of life (an indemnity contract), or could provide a cash lump sum, or
an annuity, to contribute towards the costs of care.

A group version of the contract would enable an employer to provide long-term care cover to
employees and their spouses and parents.

Unit-linked contracts
Any of the above types of contract can be written in a unit-linked form, although normally only
contracts with a significant investment element are written in this way. A unit-linked contract enables
consumers either to obtain a higher expected level of benefit for a given premium or to pay a lower
expected level of premium for a given level of benefit, than under a comparable non-linked version of
the contract. This occurs because the consumer accepts a significant element of risk, mostly
investment risk. By accepting greater risk, the consumer gains a higher expected return, at the
expense of a possibility that the return will be lower than might have been achieved from a non-linked
contract.

In addition, a unit-linked contract can offer flexibility in the types and levels of cover included and the
ability to vary premiums according to need.

Index-linked contracts
An index-linked contract enables the consumer to obtain a benefit that is guaranteed to move in line
with the performance of an index specified in the contract. Normally the index will be an investment
or economic one. Premiums may move in line with the same index, or may be fixed in monetary
terms.

With and without profits (participating) contracts

A life insurance contract is with profits if the policyholder is entitled to receive part of the surplus of
the company or of a sub-fund within the company. The extent of the entitlement is usually at the
discretion of the company. Without profits contracts do not have this profit participation feature.

Liability insurance
Liability insurance provides indemnity where the insured, owing to some form of negligence, is
legally liable to pay compensation to a third party. Any legal expenses relating to such liability are
usually also covered. (An illegal act of negligence will often invalidate the cover.) The extent of any
legal liability may depend on the prevailing legislation. For marine and aviation liability,
international law is likely to prevail. For classes such as motor and employers’ liability, national laws
are likely to apply.

The basic benefit provided by liability insurance is an amount to indemnify the policyholder fully
against a financial loss. However, subject to any statutory requirements, this benefit may be restricted

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by a maximum specified amount per claim or per event (this may involve more than one claim), or an
aggregate maximum per year, or by an excess, when the first part of any claim is not paid.

Subject to the details of any reinstatement clause, payment of any benefits may result in a cancellation
of cover or the need for a further premium.

The main types of liability insurance are:

 employers’ liability
 motor third party liability
 public liability — often linked to other types of insurance such as property, marine etc.
 product liability
 professional indemnity

(Motor third party liability is a particular type of public liability insurance, but is usually treated
separately because of the large volumes of cover written in most territories.)

Employers’ liability
This insurance indemnifies the insured against legal liability to compensate an employee or their
estate for accidental bodily injury, disease or death suffered, owing to negligence of the employer, in
the course of employment. As well as accidents perils covered include exposure to harmful
substances or harmful working conditions.

Motor third party liability

This insurance indemnifies the owner of a motor vehicle against compensation payable to third parties
for death, personal injury or damage to their property. In most countries such cover is compulsory,
with or without an upper limit on the amount of compensation. The cover provided may or may not be
limited to that required by legislation.

Public liability
The insured is indemnified against legal liability for the death of or bodily injury to a third party or for
damage to property belonging to a third party, other than those liabilities covered by other liability
insurance.

As this type of insurance forms part of many types of insurance policy, the insured perils will relate to
the type of policy. For example, compensation for a dog bite may be covered by a household policy,
while compensation for injury from a falling object may be covered by a commercial policy held by a
builder.

Product liability
This insurance indemnifies the insured against legal liability for the death of or bodily injury to a third
party or for damage to property belonging to a third party, which results from a product fault.

Here the perils depend greatly on the nature of the product being produced, but include faulty design,
faulty manufacture, faulty packaging and incorrect or misleading instructions.

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Professional indemnity
The insured is indemnified against legal liability resulting from negligence in the provision of a
service, e.g. unsatisfactory medical treatment or incorrect advice from an actuary, solicitor etc.

The perils here depend on the profession of the insured. Examples include wrong medical diagnosis,
error in medical operation and error in an actuarial report.

Property damage insurance

The main characteristic is to indemnify the policyholder. However, here the indemnity is against loss
of or damage to material property.

The main types of property that are subject to such damage are:

 residential building (e.g. house)

 moveable property (e.g. contents of house)
 commercial building (e.g. office)
 land vehicles (e.g. car)
 marine craft
 aircraft

The benefit is often the amount to indemnify the insured against the value of the loss or damage, at
the time the incident occurs, subject to any limits or excesses. Household contents cover is frequently
written on a “new for old” basis, where new goods are provided to replace lost or damaged goods,
whatever their age and condition.

In respect of household and commercial buildings, fire is the principal peril insured against but
policies can cover many other perils such as explosion, lightning, theft, storm and flood. Damage to
the insured property caused by measures taken to put out a fire is also covered.

Theft is the major peril for moveable property.

For motor property, the perils include accidental or malicious damage to the insured vehicle, and fire
or theft of that vehicle. In many countries, including the UK, this cover is typically provided together
with motor third party cover within a single policy, whilst in other countries it may be provided in a
separate policy.

The following perils relate specifically to marine hull cover, but similar perils are covered for marine
cargo, marine freight and aviation insurance: perils of the seas (or other navigable waters), fire,
explosion, jettison, piracy etc.

Financial loss insurance

Financial loss insurance can be categorised as follows:

 pecuniary loss
 fidelity guarantee
 business interruption cover (also known as consequential loss)

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The benefit provided is indemnity against financial losses arising from a peril covered by the policy.

Pecuniary loss, which includes mortgage indemnity guarantee insurance, protects the insured against
bad debts or other failure of a third party.

Fidelity guarantee covers the insured against financial losses caused by dishonest actions by its
employees (fraud or embezzlement). These will include loss of money or goods owned by the insured
or for which the insured is responsible and reasonable fees incurred in establishing the size of the loss
(paid to auditors or accountants, for example).

Business interruption cover indemnifies the insured against losses made as a result of not being able
to conduct business for various reasons specified in the policy, for example fire at the insured’s or a
neighbouring property.

Personal accident insurance

Benefits are usually specified fixed amounts in the event that an insured party (this may include the
policyholder’s family as well as the policyholder) suffers the loss of one or more limbs or other
specified injury. This is not indemnity insurance because it is not possible to quantify the value of the
loss, for instance, of an arm.

Here the perils are any form of accident that results in the loss of limbs or other specified injury.

Health insurance
Health insurance, in its narrowest sense, provides money for medical treatment. As such, it is
indemnity insurance. However, only part of the cost may be provided, or benefits may be a fixed
amount regardless of the actual cost of treatment, and hence health insurance can be included with
fixed benefit insurances. Hospital expense plans also exist which pay a fixed amount for each day the
patient is treated in hospital as an in-patient.

Health insurance cover is subject to the primary peril of the need for treatment in a hospital.

Unemployment insurance
This provides a lump sum or an income stream, usually of no more that a year’s duration, in the event
of the policyholder being made redundant. Its purpose is to provide additional funds to maintain the
policyholder’s lifestyle and service any debts for a short period while new employment is sought.

Defined benefit scheme

A scheme where the scheme rules define the benefits independently of the contributions payable, and
benefits are not directly related to the investments of the scheme. The scheme may be funded or
unfunded.

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Subject CA1 Principal terms 2016

Defined contribution scheme

A scheme providing benefits where the amount of an individual member’s benefits depends on the
contributions paid into the scheme in respect of that member increased by the investment return
earned on those contributions.

Income drawdown
Some defined contribution arrangements allow for “income drawdown”. Under such an arrangement
instead of buying an annuity the fund remains invested and the member withdraws an amount of the
fund each year. This may be just the income earned on the fund or may also include some of the fund
capital.

There may be legislative restrictions on the:

 amount of the fund that can be withdrawn each year

 age at which drawdown must cease and a pension must be purchased.

One of the main drivers behind the “income drawdown” approach is that, should the member die
before having to secure an annuity, the member’s heirs can inherit the balance of the fund. However,
income drawdown carries several risks for the member:

 if only the income earned on the fund is taken each year the member’s income could be volatile

 if too high a level of income is taken the capital could potentially reduce to zero before the
member dies leaving the member dependent on the state at the end of his or her life

 the charges taken in relation to administering the arrangement may be high

 the remaining fund on the member’s death may be insufficient to provide adequate benefits for a
dependant

 there may be a tax charge on the residual fund on the member’s death.

Reinsurance
There are many variations of the basic types of reinsurance, and contracts are often tailored to meet
the particular needs of the ceding company and reinsurer concerned. However, all reinsurance
contracts are based on the same underlying principles.

Proportional reinsurance
Under proportional reinsurance, the reinsurer covers an agreed proportion of each risk. This
proportion may be constant for all risks covered (called quota share reinsurance) or may vary by risk
covered (called surplus reinsurance). Both forms have to be administered automatically, and therefore
require a treaty.

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2016 Principal terms Subject CA1

Quota share
Under quota share reinsurance a fixed percentage of each and every risk is reinsured. Quota share is
widely used by ceding providers to spread risk, write larger portfolios of risk and encourage
reciprocal business.

Surplus reinsurance
Here, the treaty specifies a retention level and a maximum level of cover available from the
reinsurer. For high volume business such as life assurance or personal lines general insurance, the
maximum cover and the retention level are specified in the treaty. For commercial covers, such as
commercial property and business interruption, the ceding provider can select, for each individual
risk, the retention and the amount to be ceded. The proportion of risk ceded is then used in the same
way as for quota share.

Non-proportional reinsurance
Proportional reinsurance does not cap the cost of very large claims that may occur, either as a single
claim, or a set of claims from related incidents, or on an insurer’s whole account. “Large” in this
context means large relative to the ceding provider’s solvency margin or annual premiums. Non-
proportional reinsurance also stabilises the technical results of the ceding provider by reducing claims
fluctuations. It enables the provider to accept risks that might give rise to large claims.

Excess of loss reinsurance

Excess of Loss (XL) reinsurance is non-proportional cover where the cost to a ceding company of
such large claims is capped with the liability above a certain level being passed to a reinsurer.
However, if the claim amount exceeds the upper limit of the reinsurance, the excess will revert back
to the ceding company. Variations of this form of reinsurance cover exist to limit a ceding company’s
losses.

The reinsurer agrees to indemnify the ceding company for the amount of any loss above a stated
Excess Point. More usually, the reinsurer will give cover up to a stated Upper Limit, with the ceding
company purchasing further layers of XL cover, which stack on top of the primary layer, from
different reinsurers. The higher layer cover(s) come into operation on any particular loss only when
the lower layer cover has been fully used. There are three main types of excess of loss reinsurance:

 Risk XL
 Aggregate XL
 Catastrophe XL

Risk excess of loss (Risk XL)

This is a type of excess of loss reinsurance that relates to individual losses. It affects only one insured
risk at any one time.

Where a risk event can only result in the payment of the full sum insured, or no payment at all, there
is no difference between the claim amounts under individual risk XL and surplus reinsurance. This is
the case with term assurance on a single life — either the life assured dies within the term or not, and

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Subject CA1 Principal terms 2016

there is no possibility of a claim for less than the full sum insured. The two types of reinsurance differ
if there is a claim for less than the full sum insured.

Aggregate excess of loss (Aggregate XL)

Events can occur which involve losses to several insured risks within a period of perhaps a year. Such
events could lead to an aggregation of claims. Individually, each claim might not be of exceptional
size, but collectively the aggregate cost might be damaging to the ceding provider’s gross account. A
winter influenza epidemic is an example of where aggregation of losses can occur.

The conventional Risk XL treaty, by treating each claim as a separate loss, will fail to protect the
ceding provider adequately against the aggregate cost of such losses. Aggregate XL covers the
aggregate of losses, above an excess point and subject to an upper limit, sustained from a defined peril
(or perils) over a defined period, usually one year. When all perils are covered for a ceding
company’s whole account, or for a major class of business within the whole account, this is
sometimes referred to as Stop Loss reinsurance.

Catastrophe excess of loss (Catastrophe XL)

The aim of catastrophe reinsurance is to reduce the potential loss, to the ceding company, due to any
non-independence of the risks insured. The cover is usually only available on a yearly basis and has
to be renegotiated each year.

The reinsuring company will agree to pay out if a “catastrophe”, as defined in the reinsurance
contract, occurs. There is no standard definition of what constitutes a catastrophe.

The reinsurance contract will also specify how much the reinsuring company will pay if a catastrophe
occurs. Typically this might be the excess of the total claim amount over the ceding provider’s
catastrophe retention level. The reinsuring company’s liability in respect of a single catastrophe claim
would be subject to a maximum amount and any amount above this would fall back on the ceding
company.

END

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Subject CA1
Actuarial Risk Management

Syllabus with Cross referencing

to the Core Reading

for the 2016 exams

1 June 2015
Subject CA1 — Actuarial Risk Management

Aim

The aim of the Actuarial Risk Management subject is that upon successful completion, the candidate
should understand strategic concepts in the management of the business activities of financial
institutions and programmes, including the processes for management of the various types of risk
faced, and be able to analyse the issues and formulate, justify and present plausible and appropriate
solutions to business problems.

Links to other subjects

Each of Subjects CT1–CT8 provides principles and tools that are built upon in Actuarial Risk
Management.

The Specialist Technical Subjects ST1–ST9 and the Specialist Applications Subjects SA1–SA6 use
the concepts developed in this subject to solve complex problems, to produce coherent advice and to
make recommendations in specific practice areas.

Objectives

On the successful completion of this subject the candidate will be able to:

1 How to do a professional job (Unit 1)

1.1 Describe how actuaries can contribute to meeting the business needs of their clients and
other stakeholders.

1.2 Describe the statutory roles that may be required of actuaries in pensions and insurance,
both in the public and private sectors.

1.3 Outline the professionalism framework of the Institute and Faculty of Actuaries and the
Financial Reporting Council.

1.4 Describe the factors and issues to be taken into account when doing a professional job.

1.5 Describe the Actuarial Control Cycle and explain the purpose of each of its components.

1.6 Demonstrate how the Actuarial Control Cycle can be applied in a variety of practical
commercial situations, including its use as a Risk Management Control Cycle.

2 Stakeholders and their needs (Unit 2)

2.1 Identify the clients that actuaries advise in both the public and private sectors and the
stakeholders affected by that advice.

2.2 Describe how stakeholders other than the client might be affected by any actuarial
advice given.

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2.3 Describe the functions of the clients and potential clients that actuaries advise and the
types of advice that actuaries might give to their clients.

2.4 Explain why and how certain factual information about the client should be sought in
order to be able to give advice.

2.5 Explain why subjective attitudes of clients and other stakeholders – especially towards
risk – are relevant to giving advice.

2.6 Distinguish between the responsibility for giving advice and the responsibility for taking
decisions.

2.7 Describe the main providers of benefits on contingent events.

2.8 Describe how products, schemes, contracts and other arrangements can provide benefits
on contingent events which meet the needs of clients and stakeholders.

2.9 Describe the ways of analysing the needs of clients and stakeholders to determine the
appropriate benefits on contingent events to be provided by financial and other products,
schemes, contracts and other arrangements.

3 General environment

3.1 Risk environment (Unit 3)

3.1.1 Describe the risk management process for a business that can aid in the design of
products, schemes, contracts and other arrangements to provide benefits on
contingent events.

3.1.2 Describe how risk classification can aid in the design of products, schemes,
contracts and other arrangements that provide benefits on contingent events.

3.1.3 Discuss the difference between systematic and diversifiable risk.

3.1.4 Discuss risk appetite and the attainment of risk efficiency.

3.1.5 Describe credit risk and the use of credit ratings.

3.1.6 Describe liquidity risk.

3.1.7 Describe market risk.

3.1.8 Describe operational risk.

3.1.9 Describe business risk.

3.1.10 Describe attitudes to and methods of risk acceptance, rejection, transfer and
management for stakeholders.

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Subject CA1 — Actuarial Risk Management

3.1.11 Discuss the portfolio approach to the overall management of risk, including the
use of diversification and avoidance of risk concentrations.

3.1.12 Distinguish between the risks taken as an opportunity for profit and the risks to
be mitigated.

3.1.13 Describe the principle of pooling risks.

3.1.14 Describe the methods of transferring risks.

3.1.15 Describe how enterprise risk management can add value to the management of a
business.

3.1.16 Describe the risks and uncertainties affecting:

 the level and incidence of benefits payable on contingent events

 the overall security of benefits payable on contingent events

3.2 Regulatory environment (Unit 4)

3.2.1 Describe the principles and aims of prudential and market conduct regulatory
regimes.

3.2.2 Explain the concept of information asymmetry.

3.2.3 Explain how certain features of financial contracts might be identified as unfair.

3.2.4 Discuss the implications of a requirement to treat the customer fairly.

3.3 External environment (Unit 5)

Describe the implications for the main providers of benefits on contingent events of:

 legislation — regulations
 State benefits
 tax
 accounting standards
 capital adequacy and solvency
 corporate governance
 risk management requirements
 competitive advantage
 commercial requirements
 changing cultural and social trends
 demographic changes
 environmental issues
 lifestyle considerations

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 Subject CA1 — Actuarial Risk Management

 international practice
 technological changes

3.4 Investment environment (Unit 6)

3.4.1 Discuss the cashflows of simple financial arrangements and the need to invest
appropriately to provide for financial benefits on contingent events.

3.4.2 Demonstrate a knowledge and understanding of the characteristics of the

principal investment assets and of the markets in such assets.

3.4.3 Explain the principal economic influences on investment markets.

3.4.4 Describe the main features of the behaviour of market price levels and total
returns and discuss their relationships to each other.

3.4.5 Discuss the theoretical and historical relationships between the total returns and
the components of total returns, on equities, bonds and cash, and price and
earnings inflation.

3.5 Capital requirements (Unit 7)

3.5.1 Discuss why the main providers of benefits on contingent events need capital.

3.5.2 Describe how the main providers of benefits on contingent events can meet,
manage and match their capital requirements.
3.5.3 Discuss the implications of the regulatory environment in which the business is
written for provisioning and capital requirements.

3.5.4 Discuss different measures of capital needs.

3.5.5 Discuss the relative merits of looking at an economic balance sheet in order to
consider the capital requirements of a provider of benefits on contingent events.

3.5.6 Discuss the use of internal models for assessment of economic and regulatory
capital requirements.

4 Specifying the problem

4.1 Contract design (Unit 8)

4.1.1 Discuss the factors to be considered in determining a suitable design for

financial structures e.g. products, schemes, contracts or other arrangements that
will provide benefits on contingent events in relation to:

 the characteristics of the parties involved

 the risk appetite or risk aversion of the parties involved
 the level and form of benefits to be provided

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Subject CA1 — Actuarial Risk Management

 any options or guarantees that may be included

 the benefits payable on discontinuance or transfer of rights
 the method of financing the benefits to be provided
 the choice of assets when benefits are funded
 the charges that will be levied
 the capital requirements

4.1.2 Describe how the design of products, schemes, contracts and other arrangements
can be used to help develop corporate human resource strategy.

4.2 Project planning and management (Unit 9)

4.2.1 Describe the process of project management.

4.2.2 Show how actuarial techniques can be used in the assessment of capital
investment projects and cost-benefit analyses.

4.2.3 Discuss how the risks of the project are taken into account in project
management.

5 Data (Unit 10)

5.1 Discuss the data requirements for determining values for assets, future benefits and
future funding requirements.

5.2 Describe the checks that can and should be made on data.

5.3 Describe the circumstances under which the ideal data required might not be available
and discuss ways in which this problem may be overcome.

5.4 Describe how to determine the appropriate grouping of data to achieve the optimal level
of homogeneity.

6 Risk management (Unit 11)

6.1 Discuss the issues surrounding the management of risk.

6.2 Describe the tools that can be used to aid the management of risk.

6.3 Discuss the methods of measuring risk that can be used by the main providers of benefits
on contingent events.

6.4 Describe how risks with low likelihood but high impact might be managed.

6.5 Discuss the use of scenario analysis, stress testing and stochastic modelling in the
evaluation of risk

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7 Producing the solution

7.1 Modelling (Unit 12)

7.1.1 Describe the approaches available to produce the solutions.

7.1.2 Describe the use of actuarial models to support the methodology used in terms
of:

 the objectives of and requirements for building a model

 the basic features of a model required to project future cash and revenue
flows

 the use of these models for:

– pricing or setting future financing strategies

– risk management

– assessing the capital requirements and the return on capital or the

funding levels required

– assessing the provisions needed for existing commitments to provide

benefits on contingent events

– pricing and valuing options and guarantees

 how sensitivity analysis of the results of the models can be used to help
decision making

7.2 Assumption setting (Unit 13)

Describe the principles behind the determination of assumptions as input to a model

relevant to producing a specific solution having regard to:

 the types of information that may be available to help in determining the

assumptions to be used

 the extent to which each type of information may be useful, and the other
considerations that may be taken into account, in deciding the assumptions

 the level of prudence in the assumptions required to meet the objectives of the client

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Subject CA1 — Actuarial Risk Management

7.3 Expenses (Unit 14)

7.3.1 Describe the types of expenses that the providers of benefits on contingent
events must meet.

7.3.2 Describe how expenses might be allocated when pricing products, schemes,
contracts or other arrangements.

7.4 Developing the cost and the price (Unit 15)

7.4.1 Discuss how to determine the cost of providing benefits on contingent events.

7.4.2 Discuss the factors to take into account when determining the appropriate level
and incidence of contributions to provide benefits on contingent events.

7.4.3 Discuss the factors to take into account when determining the price or the
contributions to charge for benefits on contingent events.

7.4.4 Discuss the influence of provisioning or reserving requirements on pricing or

setting financing strategies.

7.5 Investment management (Unit 16)

7.5.1 Discuss the principles and objectives of investment management and analyse the
investment needs of an investor, taking into account liabilities, liquidity
requirements and the risk appetite of the investor.

7.5.2 Discuss the different methods for the valuation of individual investments and
demonstrate an understanding of their appropriateness in different situations.

7.5.3 Discuss the different methods for the valuation of portfolios of investments and
demonstrate an understanding of their appropriateness in different situations.

7.5.4 Show how actuarial techniques and asset/liability modelling may be used to
develop an appropriate investment strategy.

7.5.5 Discuss methods of quantifying the risk of investing in different classes and sub-
classes of investment.

7.5.6 Describe the use of a risk budget for controlling risks in a portfolio.

7.6 Provisioning (Unit 17)

7.6.1 Discuss the different reasons for the valuation of the benefits from financial and
other products, schemes, contracts and other arrangements and the impact on
the choice of methodology and assumptions.

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 Subject CA1 — Actuarial Risk Management

7.6.2 Discuss how to determine values for provisions in terms of:

 the need for placing values on provisions and the extent to which values
should reflect risk management strategy

 the principles of “fair valuation” of assets and liabilities and other “market
consistent” methods of valuing the liabilities

 the reasons why the assumptions used may differ in different circumstances

 the reasons why the assumptions and methods used to place a value on
guarantees and options may differ from those used for calculating the
accounting provisions needed

 the use of replicating portfolios for valuing liabilities

 the use of stochastic deflators and other stochastic discount methods

 how sensitivity analysis can be used to check the appropriateness of the

values

and be able to perform calculations to demonstrate an understanding of the

valuation methods.

7.6.3 Describe different methods of allowing for risk in cash-flows.

7.6.4 Discuss different methods of allowing for uncertainty in present values of

liabilities.

7.6.5 Discuss the purpose of and uses for equalisation reserves.

7.6.6 Describe the influence of comparisons with market values.

7.7 Relationship between assets and liabilities (Unit 18)

7.7.1 Describe the principles of investment and the asset/liability matching

requirements of the main providers of benefits on contingent events.

7.7.2 Discuss the use of portfolio theory to take account of an investor's liabilities.

7.7.3 Discuss the need to monitor investment performance and to review investment
strategy.

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Subject CA1 — Actuarial Risk Management

8 Living with the solution

8.1 Maintaining profitability (Unit 19)

Describe how the main providers of benefits on contingent events can control and
manage the cost of:

 payments arising on contingent events

 expenses associated with the payment of benefits on contingent events

8.2 Determining the expected results (Unit 20)

8.2.1 Describe how a provider’s expected results can be projected.

8.2.2 Discuss the possible sources of surplus/profit and the levers that can control the
amount of surplus/profit.

8.3 Reporting actual results (Unit 21)

8.3.1 Describe the reports and systems which may be set up to control the progress of
the financial condition of the main providers of benefits on contingent events.

8.3.2 Describe the reports and systems which may be set up to monitor and manage
risk at the enterprise level.

8.3.3 Discuss the issues facing the main providers of benefits on contingent events
relating to reporting of risk.

8.4 Asset management (Unit 22)

Describe the principles of asset management and allocation.

8.5 Capital management (Unit 22)

Describe the principles of capital management.

8.6 Surplus management (Unit 22)

8.6.1 Describe why a provider will carry out an analysis of the changes in its
surplus/profit.

8.6.2 Describe how any surplus/profit arising may be distributed.

8.6.3 Discuss the issues surrounding the amount of surplus/profit that may be
distributed at any time and the rationale for retention of surplus/profit.

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 Subject CA1 — Actuarial Risk Management

8.7 Insolvency and closure (Unit 23)

Discuss the issues that need to be taken into account on the insolvency or closure of a
provider of benefits on contingent events.

8.8 Options and guarantees (Unit 24)

Discuss the issues surrounding the management of options and guarantees.

9 Monitoring (Unit 25)

9.1 Describe how the actual experience can be monitored and assessed, in terms of:

 the reasons for monitoring experience

 the data required
 the process of analysis of the various factors affecting the experience
 the use of the results to revise models and assumptions

9.2 Describe how the results of the monitoring process in the Actuarial Control Cycle or the
Risk Management Control Cycle are used to update the financial planning in a
subsequent period.

10 Have an understanding of the principal terms used in financial services and risk
management. (Unit 26)

END OF SYLLABUS

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