EXAMINATION. 8 April 2005 (pm) Subject ST3 General Insurance Specialist Technical. Time allowed: Three hours INSTRUCTIONS TO THE CANDIDATE

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1 Faculty of Actuaries Institute of Actuaries EXAMINATION 8 April 2005 (pm) Subject ST3 General Insurance Specialist Technical Time allowed: Three hours INSTRUCTIONS TO THE CANDIDATE 1. Enter all the candidate and examination details as requested on the front of your answer booklet. 2. You have 15 minutes at the start of the examination in which to read the questions. You are strongly encouraged to use this time for reading only, but notes may be made. You then have three hours to complete the paper. 3. You must not start writing your answers in the booklet until instructed to do so by the supervisor. 4. Mark allocations are shown in brackets. 5. Attempt all 8 questions, beginning your answer to each question on a separate sheet. 6. Candidates should show calculations where this is appropriate. AT THE END OF THE EXAMINATION Hand in BOTH your answer booklet, with any additional sheets firmly attached, and this question paper. In addition to this paper you should have available the 2002 edition of the Formulae and Tables and your own electronic calculator. ST3 A2005 Faculty of Actuaries Institute of Actuaries

2 1 You are the actuary to a general insurance company which writes only employers liability insurance. List the data you require to carry out an assessment of the appropriateness of the risk premiums. [8] 2 You are the general insurance actuary for a small insurance company which writes only coach fleet and car fleet commercial motor insurances. Describe the differing claims characteristics of these two types of fleets. [7] 3 Explain the importance of relevant, accurate data for a general insurance company underwriting private motor insurance. [8] 4 You are the general insurance actuary to a company which writes only commercial property insurance. Describe the following characteristics of this class of business: (i) purpose and benefits [2] (ii) perils covered [1] (iii) exposure measure [1] (iv) claims [4] (v) rating factors [2] [Total 10] 5 You are the Chief Actuary working for a general insurance company that writes only commercial property business. The Board has indicated that it wishes to take over a similar company with whom your company is in direct competition, but has not yet made any formal approach. Outline the major actuarial investigations that you would undertake in order to assess the viability of this proposal. [10] ST3 A2005 2

3 6 You are an actuary working for a small, general insurance company that specialises only in long-tailed insurance risks in its local insurance market. The company has a moderate level of free assets. The Board, who require a risk averse investment strategy, has asked for a review of the investment guidelines given to the company s investment managers. It is assumed that there are no regulatory investment restrictions. (i) Outline the instructions that would be given to the investment managers in respect of the assets that they may or may not hold, including any relevant limits. [6] At a recent Board meeting, one of the members suggested that, given the long-tailed nature of the risks insured and the current low historic level of the stock market, the equity proportion of the investment portfolio should be increased to benefit from future stock market increases. (ii) Explain the advantages and disadvantages of his suggestion for the company. [6] Another Board member has suggested increasing the proportion invested in indexlinked Government bonds. (iii) Explain the advantages and disadvantages of this suggestion compared with that given to the previous Board member. [4] [Total 16] 7 A global relief agency provides humanitarian assistance to victims of natural disasters in poor countries around the world. It is looking into its sources of funding for large natural disasters and is thinking of buying a catastrophe insurance policy. The policy pays out a fixed sum of $100m if a large natural catastrophe leads to more than 500 deaths during the term of the policy. The premium for the policy is likely to exceed $10m per annum. (i) (ii) (iii) Discuss the advantages and disadvantages to the relief agency of purchasing such a policy. [5] Discuss the advantages and disadvantages to the Insurer of writing such a policy. [4] Two different insurance providers are competing to write this policy. Company A thinks that the number of such events has a Poisson distribution with Poisson parameter of 10%, while Company B estimates the Poisson parameter to be 8.33%. Company A requires a return on capital of 10% while Company B requires a return on capital of 15%. Both companies allocate capital to this contract using the same methodology. The amount of capital is set to ensure that the probability of ruin for this contract on a standalone basis is less than 10%. Using approximations where appropriate, calculate which of the two companies will have the higher premium. [9] [Total 18] ST3 A PLEASE TURN OVER

4 8 You have just been appointed as the actuary to a small general insurance company which writes two classes of business, A and B, throughout the territory. All business is written through insurance brokers. The only financial information you have been presented with is shown below. All figures are as at end Class A Gross written premium 1, Net written premium Net earned Premium Claims (all after reinsurance recoveries) Paid total to date Current case estimates IBNR/IBNER Total claims cost Expenses Commission Investment return Profit Class B Gross written premium 1,000 1,250 1,500 1,750 Net written premium 950 1,188 1,425 1,662 Net earned Premium 950 1,069 1,306 1,543 Claims (all after reinsurance recoveries) Paid total to date Current case estimates IBNR/IBNER Total claims cost 690 1, ,120 Expenses Commission Investment return Profit 40 (486) 23 5 (i) Comment on the financial characteristics (including financial trends) of each of the classes of business the company writes, using any appropriate financial ratios. [14] (ii) State, with reasons, which classes of business A and B are likely to be. [4] (iii) Describe the issues the company will face in the short term and any actions you would recommend. [5] [Total 23] END OF PAPER ST3 A2005 4

5 Faculty of Actuaries Institute of Actuaries EXAMINATION April 2005 Subject ST3 General Insurance Specialist Technical EXAMINERS REPORT Introduction The attached subject report has been written by the Principal Examiner with the aim of helping candidates. The questions and comments are based around Core Reading as the interpretation of the syllabus to which the examiners are working. They have however given credit for any alternative approach or interpretation which they consider to be reasonable. M Flaherty Chairman of the Board of Examiners 28 June 2005 Faculty of Actuaries Institute of Actuaries

6 Subject ST3 (General Insurance Specialist Technical April 2005 Examiners Report 1 This question asked candidates to consider the risk premium. Those who spent time talking about expenses, commission etc did not gain marks for such comments. On the whole though this question was answered very well. Policy Data For each policy Dates on cover Dates of endorsements and change in cover All rating factor details: Trade / Industry / Occupation Turnover Number of employees Health and safety policies Source of business Materials handled Processes involved Location Payroll Exposure Cover / exclusions Limit of indemnity Past claims experience Size of deductible Details of risk premiums charged, may need to be a proxy Claims Data Date of occurrence Date claim reported Date of re-opening Dates and amounts of payments Estimates, if they exist, of amounts outstanding Rating factor details as they were at the time of the claim and/or Link to policy information Type of claim, i.e. injury or disease Type of peril Page 2

7 Subject ST3 (General Insurance Specialist Technical April 2005 Examiners Report Dates of settlement Other data Industry statistics to back up own data where it is sparse Changes in underwriting / claims handling / policy conditions Inflation statistics for wage inflation, court award inflation and care inflation Information about any legislative changes which will have impacted in past and any that may impact future experience 2 This question asked for the differing claims characteristics. Many candidates listed claims characteristics without identifying how they differed between the two types of business. Some candidates also described claims characteristics and then said that they would be similar. Neither of these approaches would have gained many marks if any. Coach fleet may take longer to settle small claims as the insured may be unwilling to take a coach out of service to rectify minor cosmetic damage. This will depend on how busy the company is. Lower theft claim frequency likely for coach fleet Overall claim frequency could be higher or lower depending upon circumstances, e.g. mileage travelled, area driven, area kept. If a coach fleet has a total loss this will be a large claim. Also if all coaches are stored together overnight there is potential for an aggregation of risk, e.g. fire. This is less likely to be a risk for a car fleet. Leads to a more skewed claims cost distribution. Average claims size of coach fleet third party property damage claims will be higher than for a car fleet. This will include some total losses in respect of third party vehicles. Hence settlement delays will be greater for coach fleets. For a coach fleet there is a potential accumulation of risk There will generally be fewer vehicles per fleet for coaches and hence more random claims experience. Page 3

8 Subject ST3 (General Insurance Specialist Technical April 2005 Examiners Report Likely to be more overseas exposure for coaches and hence possible notification delays and currency issues. Fewer small claims for coaches as generally higher excesses on the policies. May be different legislation impacting upon coach passenger claimants compared with car fleets. If a coach was full of passengers and had an accident could be many individuals hurt or killed which could lead to much larger claims than if a car had a similar accident. Dealing with such a coach claim would take a long time and be very expensive. Again if a coach hit another vehicle it could do more damage than a car and so bodily injury claims are more likely and likely to have a higher average cost. 3 There were many points that could be made in the solution to this question. Several candidates however concentrated on the issue of over / under charging and effect upon expenses. Hence they missed out on several of the other points. Marks for this question were generally very low. Policy, claims and expense data are essential for reserving to ensure sufficient funds are retained to pay future claims and to highlight any concerning trends This is also likely to be required for insurance Regulatory purposes, accounts or otherwise both to satisfy reserving requirements and to demonstrate that the company is run in a sound manner, e.g. with regards to investment strategy, capital use and planning. Similar data is also required for pricing to ensure that there is no adverse selection and to aim to maximise profits. More accurate / complete data enables better pursuit of these goals Relevant, accurate data is required both for assessing appropriate levels of reinsurance and to provide to reinsurers in order to maximise the chance of obtaining the desired cover for an appropriate premium. Such data is also required for persistency, portfolio movements and quote strike rate management information to assess the business you have on your books at any particular time. In a competitive market such as motor, improved data can give the edge in terms of more accurately pricing risks to win more profitable business and help avoid the less profitable categories. Without relevant accurate data, poor underwriting decisions become more likely Page 4

9 Subject ST3 (General Insurance Specialist Technical April 2005 Examiners Report Customers will not appreciate providing irrelevant information and will not want to take the time. So the company must restrict info requested to just the minimum to enable underwriting, in order to ensure volumes of business are optimised. Exclusions / Excesses must be recorded correctly to ensure that the correct policy cover information is applied in the event of a claim. This information underpins management decisions. Poor data may result in poor decisions being made Relevant, accurate information may help to prevent fraudulent behaviour 4 This question was generally well answered with some candidates scoring nearly full marks. Purpose is to indemnify the policyholder against loss or damage to their commercial property e.g. office, shop, factory. In addition there may be business interuption cover Benefit is the amount indemnified for loss or damage subject to limits or excess. Perils covered are fire principally but also including explosion, lightning, theft, storm and flood. In addition there may be business interuption. Exposure used is the sum insured year however there are two complications: Stock amounts may fluctuate considerably. Stock may be covered on a declaration basis, determined retrospectively with an adjustment premium. No standard way of allowing for inflation in the policy. Claims characteristics Claims arise from sudden and determinable events (except subsidence) Notification delays are short apart from subsidence Different inflation rates affect buildings, contents and business interuption sections Possible accumulations owing to location Generally low claim frequency compared with other property insurance Many claims likely to be impacted by reinsurance arrangements Good estimates of claims amounts can be made Page 5

10 Subject ST3 (General Insurance Specialist Technical April 2005 Examiners Report Settlement delays are generally short but can be increased if there is a need to verify the value of the stock held in a commercial property or the validity of a claim. Claims distribution is skewed as claims are fairly consistent in size with few total losses but more varied than domestic properties as the properties insured are less homogeneous. Exposed to moral hazard especially in an economic downturn. Claims may be reopened. Large claims will be subject to negotiation / arbitration about the amount of the claim Rating factors The main rating factors are monetary value, location, trade / business. Other rating factors which may be used are: EML Age of building Fire protection equipment Number of floors / floor area Surveyors report / score Construction type Excesses Indemnity period for business interuption Security / links to police station Claims history 5 Alternative approaches to this question gained marks regarding the detailed amount of information given as the examiners felt that the question did not make it clear when the actuarial investigations were due to take place. Marks were not given however for investigations of a non-actuarial nature. Even allowing for the alternative approaches most candidates mentioned only a few of the investigations that would be carried out. Many candidates concentrated on aspects of getting the data rather than investigations e.g. trends. Claims related: Frequency and Average Cost trends by Accident year, Development year and Payment year to highlight any potential new developments cost per unit exposure analysis large loss ratio Probably only have statutory accounts and returns available Page 6

11 Subject ST3 (General Insurance Specialist Technical April 2005 Examiners Report Need to investigate reserving trends in conjunction with the claims related trends e.g. UPR, (A)URR, OSCR, IBNR compare with previous years. Are there any noticeable trends? Also, investigate trends in claims handling costs and associated reserve. solvency levels and free reserves statutory solvency requirements / levels of coverage market share portfolio movements new business levels / premium volume premium rates charged if obtainable / industry premium levels the asset mix and any associated changes Funding of the takeover Alternative use of funds Restrictions on purchase anti-competitive laws. Other accounting ratio investigations important Loss/Claims ratio, Expense/Combined ratio, Commission rates, Investment returns, Profit margin, Return on capital employed, Share price / p.e. ratio reinsurance purchased, recoveries made, reinsurers security goodwill taxation and regulation policy conditions Check for any trends in the wording of audit statements weakening in the sign-off has there been any apparent Investigate recent or possible future legislation changes that may impact the business. Investigate similar trends in other potential companies Investigate the credit standing of the company Investigate the combined model office Investigate the synergies that the combined operation will have. Investigate the effect upon the benefit schemes of the two organisations. Investigate the impact upon data owing to different ICT and product structures. Investigate any savings in claims handling expenses Page 7

12 Subject ST3 (General Insurance Specialist Technical April 2005 Examiners Report Investigate the benefit of any diversification by location, different industries and different materials handled etc. 6 Part (i) of the question asked for relevant limits. Most candidates failed to give sufficient limits with many not giving any at all. Some candidates did give limits but selected very high proportion of equities which even for a GI company writing longtail business is not appropriate, especially if it is small. A lot of the answers were regarding general comments about investments for a GI company rather than the instructions given to the investment mangers. Parts (ii) and (iii) were generally well answered. (i) Content will include: guidelines for the split of assets, giving ranges for each major asset class this will most likely give maximum and minimum ranges indicate mean duration, mean maturity, maximum maturity permitted, etc. Cash (20% 30%) Fixed interest (50% 70%) Index linked (20% 40%) Equity (0% 20%) Indirect property (up to 10% of the 20% max for equity) No direct property investment Domestic currency only >80% of Fixed interest must be Govt guaranteed The remainder of Fixed interest must be AA or better Benchmark for investment return Limit equities to bluechip or equivalent Funds under management should be split broadly equal between at least two different investment managers For Cash no more than w% of funds under management with any one deposit holder. For other assets no more than x% of the insurers total assets should be invested in any one company in aggregate, etc. The insurer should not hold more than y% of any particular issue The insurer should not hold more than z% of any one company s total debt in aggregate (counter-party risk), etc. Page 8

13 Subject ST3 (General Insurance Specialist Technical April 2005 Examiners Report (ii) Advantages Returns may be higher, in which case the company would improve its overall investment performance Equity may be better matched for real, long term liabilities If currently low level of equities then to increase holding could be appropriate for diversification Disadvantages Returns may be lower, in which case the company would see worse investment performance Equity has a greater volatility of potential returns, which means there is an increase in risk Equities too long to match most liabilities Capital requirements are likely to be risk-based, which means equity treated as higher risk Equity is less liquid, which is disadvantageous in GI business where funds may be needed at short notice to cover unexpectedly high levels of claims Equity is less secure, so greater risk of default (iii) Advantages Inflation link offers some protection for real liabilities Highest level of security Long term should be a suitable match Lower volatility, so generally lower risk than equity Possible lower level of dealing expenses Page 9

14 Subject ST3 (General Insurance Specialist Technical April 2005 Examiners Report Disadvantages Appropriate term may not be available The inflation link may not be suitable (wrong inflation) Overall expected returns are lower Possibly less liquid / smaller volumes available 7 Most candidates managed to make a reasonable attempt at the first 2 parts of this question which involved a non standard product. Part (iii) proved very difficult for most candidates and hence overall the marks for this question were generally on the low side. The solution below to part (iii) was not the only one that would have been accepted by the examiners, in particular using different terms in the Taylor Series expansion would have given a different answer. (i) Advantages Guaranteed funding in the event of a large catastrophe enabling the agency to concentrate on relief efforts rather than fund raising. Certainty about the amount available for relief efforts. Enables better planning and budgeting as there is no need to build up contingency funds etc. Controls cash flow Disadvantages $10m dollars may be perceived to be a high annual cost for insurance and the relief agency does not have the funds. Contributions may not be as forthcoming if contributors realise that their money is being paid over to an insurance company. If event is near the end of the term of the policy may be difficulty in determining if the 500 deaths occur during the term of the policy. If there are no large catastrophes during the year, then the agency will lose the premium. The insurance provider is likely to add margins and profit loadings on the premiums and thus the premium for the policy is likely to be higher than the expected benefit to the agency. There may very few providers of such policies in the market i.e. Demand may outstrip supply and this may lead to the insurance provider overcharging for the policy. Page 10

15 Subject ST3 (General Insurance Specialist Technical April 2005 Examiners Report There may be delays in receiving the funds from the insurance provider as it may want evidence of the loss of life etc. The agency may be able to raise the required funds anyway from public sympathy for the victims of the disaster. Man made disasters such as civil war would not qualify for benefit under the policy. The relief agency will be working to prevent loss of life and so may in some situations not get the benefit under the policy due to its own success. In such situations, the relief agency may request some financial compensation. This may lead to disputes with the insurance provider. Need for a clear definition of what constitutes a natural disaster. Many of the events that the relief agency is concerned with may not result in great loss of life but may still be large catastrophes in terms of the numbers of people requiring assistance. Effects of inflation may reduce real level of cover Risk of insurer default. Number of deaths is not indicative of size of loss Payment is irrespective of number of deaths once it reaches 500. (ii) Advantages Fixed benefit payable on occurrence of an event leading to a valid claim. Short tailed Selling such a policy would bring in income from a new source and possibly open up the possibility of selling such policies to other relief agencies. There may be marketing advantages to being associated with the relief agency. The policy would bring catastrophe exposure to parts of the world that the provider is unlikely to be selling much insurance to. Therefore it would not aggregate much with its other catastrophe exposures (i.e. diversification). Pricing may be attractive as few companies in the market would be willing to write such policies. Page 11

16 Subject ST3 (General Insurance Specialist Technical April 2005 Examiners Report Disadvantages The definition of loss under the policy is somewhat subjective. There may be difficulties in establishing the loss of life from an event. This could lead to disputes with the relief agency. It may be difficult to price such a policy as good data may not exist on the frequency of such events (i.e. there is a greater risk that claims could exceed premiums than in other situations). The relief agency would have an incentive to exaggerate the loss of life from a particular disaster. Independent verification may be difficult to obtain. An event may occur in a part of the world where the relief agency does not operate. In such a situation, the insurer would end up paying out even through the relief agency does not spend that money providing any assistance to the victims. Difficult to reinsure at reasonable rate Volatile claims experience Liquidity issue in event of a claim Political downside if do not pay out. (iii) Loss cost for Company A = 100 * 0.1 = 10m Loss cost for Company B = 100 * = 8.33m Company A Premium = 10m + 10% * Capital Company B Premium = 8.33m + 15% * Capital Page 12

17 Subject ST3 (General Insurance Specialist Technical April 2005 Examiners Report The Capital is set such that exp ( Capital * R) is approximately equal to 0.1. where R is the root of M(R) cr = 0 M(R) 100 (1 + )R = 0. M(R) = exp(100r) = R R 2 using the Taylor Series expansion Therefore R is the root of R R R 100R 0. R = 0.02 where is the safety load Using the approximation probability of Ruin = exp( R * Capital) = 0.1 exp( 0.02 Capital) = 0.1 Capital = m / In the case of Company A, 2 = m / 100m = sqrt(1.1513) = = 10% * Capital / 10m So Premium = 10m * ( * = 20.73m In the case of Company B, = 15% * Capital / 8.33m 2 = m / 55.53m = sqrt(2.0731) = So Premium = 8.33m * (1 + = 8.33 * = 20.32m Hence company A will be more expensive. 8 Most of the candidates made a good attempt at this question, particularly part (i). The examiners were encouraged by this as this type of question has been poorly answered in the past. It demonstrated an understanding and interpretation of accounts. There was some confusion regarding at which point in time the figures related to, even though the question stated that all figures are as at end (i) Class A GWP is decreasing sharply NWP is decreasing even faster than GWP. This could be because the reinsurance premium is rising as a % GWP or that the company is buying more reinsurance as the size of the portfolio decreases. NEP = NWP so all the policies are written on the first day of the accounting period. Loss ratio is increasing over time. Page 13

18 Subject ST3 (General Insurance Specialist Technical April 2005 Examiners Report Small proportion of claims are paid a long tail class Lots of IBNR/IBNER which increases (as % of WP) as get closer to the future as would expect. Expenses are not falling as fast as premium. Could be due to claims handling costs as claims are long tail. Commission is stable at 15% of GWP, or increases from 20% to 25% as % of NEP Investment return is decreasing very slowly. Investment return is high as % of GWP Again consistent with a long tail class as substantial reserves will be held and these will be fairly stable. Profit has decreased in amount over time but as a percentage of GWP has increased over time. This is a result of the decrease of GWP with a stable reserve pot and higher proportion of investment return. Class B GWP is increasing sharply, in fact at the rate that it is falling in class A NWP is also increasing at the same rate as GWP. Percentage of GWP paid in reinsurance is constant at 5%. NEP for 2000 is the same as NWP. Could mean that same volumes were written in 1999 as in NEP for subsequent year suggests that the average policy is written mid way through the year i.e. that policies are written evenly over the year. Commission is again stable at 15% of GWP, or around 17% of NEP. Expenses start at 10% of GWP and increase slightly over time to 12% by Investment return is relatively stable at circa 3% of premium. Increasing slightly as a % GWP. Page 14

19 Subject ST3 (General Insurance Specialist Technical April 2005 Examiners Report Proportion of claims paid is far greater than class A i.e. this class is shorter tailed. IBNR/IBNER moves over time as expected. Looks like there is a large notified but not paid claim in loss ratio for this year deviates sharply from the average. Profitability has declined over time as % GWP, consistent with the rapid growth company has undertaken. Growth at this speed is often not possible without a decline in profit. (ii) Class A EL, PL anything else long tailed with reasons Class B any short tailed class, household due to large claim / weather / subsidence event in 2001 (iii) Issues Expenses are increasing over time. Need to investigate why this is happening and identify any opportunities to reduce expenses. Reinsurance costs on class A seem to be increasing. Need to investigate why and consider whether current reinsurance arrangements are the most appropriate. Profit for A as % of WP increasing in revenue accounts but underwriting profitability of business written is decreasing, cannot rely on the investment returns on long tailed class. Look at bringing class B back into profitability. Changes in mix of business within each class owing to rapid expansion / contraction. Investigate whether the reduction in volume in class A and increase in class B is intentional Investigate investment strategy. Investigate capital requirements Staff and systems, class A will need experienced staff to handle a class that is clearly decreasing over time. Staff may leave for another company once they see they have no long term future. Need plan to retain and reassure staff otherwise will lose ability to service business. Page 15

20 Faculty of Actuaries Institute of Actuaries EXAMINATION 9 September 2005 (pm) Subject ST3 General Insurance Specialist Technical Time allowed: Three hours INSTRUCTIONS TO THE CANDIDATE 1. Enter all the candidate and examination details as requested on the front of your answer booklet. 2. You have 15 minutes at the start of the examination in which to read the questions. You are strongly encouraged to use this time for reading only, but notes may be made. You then have three hours to complete the paper. 3. You must not start writing your answers in the booklet until instructed to do so by the supervisor. 4. Mark allocations are shown in brackets. 5. Attempt all 8 questions, beginning your answer to each question on a separate sheet. 6. Candidates should show calculations where this is appropriate. AT THE END OF THE EXAMINATION Hand in BOTH your answer booklet, with any additional sheets firmly attached, and this question paper. In addition to this paper you should have available the 2002 edition of the Formulae and Tables and your own electronic calculator. ST3 S2005 Faculty of Actuaries Institute of Actuaries

21 1 (i) Explain the difference between accident year accounts and funded accounts. [2] (ii) Give four examples when funded accounts could be appropriate. [2] [Total 4] 2 (i) Define the terms: (a) (b) suretyship moral hazard [2] (ii) Explain how a general insurance company writing suretyship business can minimise the risk of moral hazard in respect of the cover it provides. [4] [Total 6] 3 You are a consulting actuary who has been approached by a general insurance company, which writes more than one line of insurance business. (i) (ii) You have been asked to comment on the recent relative profitability of the different lines of business for this company. State, with reasons, the types of investigations that you will need to carry out in order to do so. [3] On completion of the above task, you are asked to comment on the company s reinsurance structure. List the types of investigations that you would carry out. [4] [Total 7] 4 A reinsurance company writes a book of catastrophe reinsurance contracts to an expected combined ratio of 60%. It estimates that its aggregate claims distribution is compound Poisson with and the claim size distribution is exponential with mean of $1m. (i) (ii) Calculate the minimum amount of capital it needs to ensure that its ultimate probability of ruin stays below 0.5%. [5] Ignoring investment income, calculate the return on capital that the reinsurer would generate if it held the amount of capital that you calculated in (i) above. [1] (iii) Suggest potential practical limitations of the above solution. [1] [Total 7] ST3 S2005 2

22 5 You are an actuary working for a general insurance company that writes a wide variety of classes of insurance. You have been asked to attend a cross-functional group looking at how to improve the company s defence against fraudulent claims. As part of your preparation you have been asked to suggest ways in which fraudulent policyholder behaviour may be reduced. Outline the suggestions you would make. [14] 6 The government of a small developing country wants to encourage the development of the agricultural sector in its country. One of the measures it has taken is to establish a specialist insurance company to provide crop insurance to farmers in its country. The insurance company would charge an annual premium and provide compensation to farmers for crop failure resulting from drought, disease or pests during the policy year. The compensation provided will equal the sum insured less the proceeds from the sale of the crop. (i) List the rating factors that the insurance company might use to set premiums. [3] (ii) Describe the characteristics of claims that the insurer can expect to receive. [5] (iii) State the factors that will influence the level of capital that the insurer will need. [5] [Total 13] 7 You are an actuary working for a general insurance company that has been in business for three years, writing only motor insurance third party liability, in a country that does not allow claims equalisation or catastrophe reserves. (i) (ii) State the required technical reserves likely to appear in the management accounts and the matters you would consider in determining the reserving methods to calculate these reserves. [18] Discuss how you would overcome any particular issues or difficulties faced in applying the methods discussed in (i). [6] [Total 24] ST3 S PLEASE TURN OVER

23 8 You are a general insurance actuary working for an insurance company which writes only household business. (i) (ii) (iii) Describe, with examples, the adjustments that may be made to the base experience to obtain the burning cost premium. [10] Explain the adjustments that may be made to the burning cost premium to calculate the premium the customer is charged when initially taking out a policy. [10] Describe any further adjustments that may be made to the premium in (ii) to derive a renewal premium. [5] [Total 25] END OF PAPER ST3 S2005 4

24 Faculty of Actuaries Institute of Actuaries EXAMINATION September 2005 Subject ST3 General Insurance Specialist Technical EXAMINERS REPORT Introduction The attached subject report has been written by the Principal Examiner with the aim of helping candidates. The questions and comments are based around Core Reading as the interpretation of the syllabus to which the examiners are working. They have however given credit for any alternative approach or interpretation which they consider to be reasonable. M Flaherty Chairman of the Board of Examiners 29 November 2005 Faculty of Actuaries Institute of Actuaries

25 Subject ST3 (General Insurance Specialist Technical) September 2005 Examiners Report 1 Most candidates had no problems with this question. (i) (ii) Accident year accounts consider all income earned and outgo incurred in a year and permit the release of profit at the end of the year. Funded accounts consider the business written in each year and do not permit the release of profits until the end of a subsequent year (usually the third year). Where underwriting year is fundamentally important Lloyd s market Reinsurance written on a policies incepting basis Significant delays in premium payment and claim settlement and in making recoveries Marine and aviation business Regulatory requirement 2 Credit for (i) part b was given to students who used the alternative definition of Making the insured event more likely to happen as a result of being insured, e.g. a household contents policyholder not taking as much care in checking that doors and windows are locked. Many candidates could not define suretyship and hence missed out on a few of the points in part (ii) or added points that were not relevant to this type of insurance. (i) (a) Insurance to provide a guarantee of performance or for the financial commitments of the insured. (b) The risk that an insured may attempt to take an unfair advantage of the insurer, for example by suppressing information relevant to the assessment of risk or by submitting a false claim. (ii) Good underwriting Suitable policy wording / exclusions Provisions of suitable cover including any limits and excesses Data sharing with other companies Analysis of claims information may highlight patterns Regular contact with insured to build confidence and understanding Page 2

26 Subject ST3 (General Insurance Specialist Technical) September 2005 Examiners Report Expert claims handling. Double trigger Obtain relevant info regarding financial status and obligations of the insured 3 Most candidates managed to make a reasonable attempt at this question. (i) Reserving analysis to check the expected ultimate liabilities for each line of business An analysis of the expenses and levies attributed to each line of business to check their allocation An analysis of cashflow for each line of business in order to work out the net present value of underwriting profits from each line of business. Determine the required level of capital to support the business Allocation of the required capital amongst the various lines of business Determine the return on capital for each line of business. Investment risk based on asset risk to assess default risk Investigation of bad debts on each class Investigation of reinsurance to assess cost effectiveness Investigate the effect of the insurance cycle for each class to see effect of likely profitability Investigate change in mix of business within each class to assess effect upon changing profitability Investigate the effect that the occurrence of large claims may have had on each line of business (ii) The amount of risk that can be retained safely having regard to the insurer s solvency position. The extent of likely exposure to accumulations of risk The need for catastrophe reinsurance and the appropriate upper and lower limits for such cover The extent for possible need for reinstatement covers Page 3

27 Subject ST3 (General Insurance Specialist Technical) September 2005 Examiners Report Competitiveness of reinsurance prices and availability of cover and technical assistance Check on strength and solvency of reinsurer. Competitors reinsurance structure Regulatory requirements Alternatives to reinsurance Cost and effectiveness of commuting existing covers Past reinsurance cost / benefit 4 This question generally resulted in either almost full marks or nil. Many candidates gaining only 1 or 2 marks with the initial definitions but not being able to carry out the calculation. (i) Probability of Ruin is approximately equal to Exp ( RU) where U = Capital required R = adjustment coefficient = α λ / c = α θ /(1 + θ) μ = $1m. α = 1 / μ = 1 θ = 1 / = R = 1 * /( ) = 0.4 Probability of Ruin = Exp ( 0.4 * U) < 0.5% 0.4 * U < ln (0.5%) 0.4 * U < U > I.e. the capital required is greater than $13.25m (ii) Return on Capital = 0.2 * / = 1.0% (iii) Model not appropriate Approximations used not correct or not appropriate Regulatory requirements may be different Ignores other business that may be written by the company Page 4

28 Subject ST3 (General Insurance Specialist Technical) September 2005 Examiners Report Future experience different from past 5 This question was on the whole better answered than the examiners had expected. The better candidates were able to show that they had considered many ways in which the fraudulent behaviour could be reduced. X-check policy cover dates against date of accident Look for multiple claims from the same claimant, surname, address, postcode, etc. Tighten underwriting criteria Check previous claims history of the policyholder at inception Introduce some form of experience rating Increase / introduce excesses Spot checks on claims of various sizes Set up confidential fraud line with possible incentives Write indemnity only policies Set up fraud department Attempt to identify any oddities about the claim, such as flood damage on a dry day Corroborate info provided by claimant with independent sources. E.g. witnesses Review previous claims history any repeat claims in internal data Consider data sharing with other companies E.g. highlight any double coverage Collaborate with police, media and other insurers to advertise penalties for fraud using specific example cases previously discovered Use of in-house / appointed repairers / loss adjusters Use of own home service sales force Settle claims by replacement items rather than cash settlement Ensure policy wording is as tight as can be with appropriate declarations of facts provided Send out claims handler to view claim incident where economically viable Page 5

29 Subject ST3 (General Insurance Specialist Technical) September 2005 Examiners Report Ensure claims handlers are well trained and receive regular refreshers Maintain good links / relations with relevant police and related authorities and share information Require original receipts to demonstrate value Require medical evidence from recognised professional Highlight penalties for fraud on policy wording Use of voice recognition techniques and recording of telephone calls for purposes of lie detection / claim verification 6 Again the examiners were pleased with the general standard of answers for this question with candidates demonstrating that they could apply their knowledge to a non standard GI product. (i) (ii) Type and mix of crops grown Geographic region in which the crops are grown Size of the farm Availability / method of irrigation Pest control techniques used Level of excess Claims history Sum insured. Most claims will be reported at the end of the growing season although some will be notified during the season. Most claims will be settled quickly, i.e. very soon after the growing season Claims size will be related to the size of farms in the country. Claim frequency likely to be low in most years There will be significant accumulations of claims from adverse weather conditions / pest epidemics. Accumulations might occur from the same geographic region or type of crop. If a period of drought / disease / pest extends over several years, then the insurer could face several years of high losses. Page 6

30 Subject ST3 (General Insurance Specialist Technical) September 2005 Examiners Report Potential for fraudulent claims if a farmer does not tend his crops properly and then claims under the insurance policy. Potential for moral hazard as farmer does not aim for highest sale price for crop as insurance will pay anyway Short tail, therefore relatively little impact from claims inflation. Quick reinsurance recoveries Potential for claim disputes regarding definition of drought / cause of crop failure. (iii) Likelihood of accumulations and catastrophes. Volatility of claims experience Level of uncertainty from poor data quality for pricing Liquidity risk Credit risk from reinsurers / policyholders / third parties The level of premiums charged in relation to expected claims (loading factor / risk margin) Desired level of ruin probability. Expected volume of business Level and variability of expenses Level and variability of investment income that the insurer is expected to generate Reinsurance structure and price. Regulatory requirements. There may be minimum capital requirements. Rating agencies. The insurer may wish to achieve a particular rating. Implicit or explicit guarantees from the government with regard to capital support in future. Required profitability Dividend policy 7 Credit was given in either part of the candidates answer for valid comments listed below in both parts (i) and (ii). Page 7

31 Subject ST3 (General Insurance Specialist Technical) September 2005 Examiners Report Although most candidates were able to list the required technical reserves, there was generally not enough discussion as to the matters to be considered in calculating such reserves. Most candidates did comment upon the fact that the company had only been in business for 3 years but did not go into enough detail as to how to deal with this. A few candidates failed to realise that third party liability insurance also covered third party liability to property damage and instead only considered third party liability to bodily injury claims. (i) All technical reserves to be stated on a gross and net basis Consideration of any regulatory issues Consideration of level of margin in reserves Consistency with existing methods Consider currency of reserves Unearned Premium Reserve 365ths method most accurate when risk is evenly spread Calculates unearned premium by multiplying office premium by ratio (365 # days since inception) / 365 But requires computer records, which should be available 24th / other similar methods less accurate Risk may not be evenly spread though need to investigate claims experience to date and probably industry data to devise a suitable earnings formula DAC UPR may be directly reduced for acquisition costs or a DAC can be created as an asset to offset the overstatement Additional Unexpired Risk Reserve Required where initial premium is considered insufficient to cover the estimated ultimate claims outgo Might assume not required, if confident in original pricing basis However, could compare with industry claims experience there may be recent trends apparent since business written Page 8

32 Subject ST3 (General Insurance Specialist Technical) September 2005 Examiners Report O/S Reported Claims Reserve / IBNER Case estimation likely to prove most fruitful as low frequency, high severity expected for this class and because the company is very young Separate allowance is required for IBNR Chain ladder techniques unlikely to be of any use for bodily injury as too little data available and not even close to being fully run-off Chain ladder could be considered for property damage but need to consider any changes in settlement procedures Bornhuetter-Ferguson method may be helpful though but must be confident in ultimate loss ratios Allowance for discounting If using an average cost per claim method then need to allow for changes in nil claims IBNR Could take a simple proportion of premium / o/s claims reserve however, not very robust as loss ratio may not be stable / affected by adverse claims experience Delay table method not viable as insufficient stats available Projection method likely to be of most use, but need an ultimate loss estimate perhaps there are industry stats available to help. Re-opened claims reserve if not included within O/S reported reserve Claims Expense Reserve With case estimation of o/s claims can include allowance for direct expenses Or can look at industry estimates to assess a proportional addition Indirect expenses will need to be based on prior estimates from business plan / model projections as the business is still very young Page 9

33 Subject ST3 (General Insurance Specialist Technical) September 2005 Examiners Report (ii) Split the data between bodily injury and property damage Try to use several different methods for estimating each reserve to ensure that the resulting reserves are sensible Approach reinsurers for technical assistance, as they are likely to have significantly more experience on which to base estimates. Actuarial consultants can provide similar assistance. More frequent reviews of claims and expense stats will ensure that most up-todate info can be fed into the process Future inflation may be different to past inflation in which case would need to allow explicitly for inflation in projections May have been trends in the past which need to be allowed for, e.g. in respect of legislative changes. All claim costs would be required to be put onto the same basis. There may have been a large individual or catastrophe claim in the three years. Would need to adjust the data for this by e.g. removing such an item from the base data and making a separate allowance at the end. Obtain any industry data 8 This was a bookwork question aimed at a particular class of business. Many candidates managed to only mention a few of the adjustments required and even fewer examples. Part (iii) of the question called for a comparison of a renewal premium with a new business premium at a point in time. Some candidates interpreted the question to mean how the renewal premium for an individual policyholder would be derived from the new business premium the policyholder was charged the previous year. The examiners considered this interpretation but did not consider it valid. (i) Unusually light / heavy experience. Claims experience fluctuates over time. An example in household is that some years suffer from storms more than others. If the experience of the base period does not appear typical the insurer must choose another base period, aggregate more years experience or apply an adjustment factor to the affected base year. Factor will be subjective. Large / exceptional claims. Have to decide whether to leave claims in, truncate them or remove them. This will depend on the extent to which Page 10