EXAMINATION. 22 April 2010 (pm) Subject ST2 Life Insurance Specialist Technical. Time allowed: Three hours INSTRUCTIONS TO THE CANDIDATE

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1 Faculty of Actuaries Institute of Actuaries EXAMINATION 22 April 2010 (pm) Subject ST2 Life 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 before 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 six 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 from the approved list. ST2 A2010 (JB v7) Faculty of Actuaries Institute of Actuaries

2 1 A company sells conventional with profits policies. Bonuses are declared using the additions to benefits simple bonus approach. The company is considering changing to a compound or super-compound bonus approach. (i) Describe the simple, compound and super-compound approaches. [2] (ii) Explain the advantage to the company of this change. [1] Over the past three years the company has declared regular bonuses of 1% p.a. using the simple approach. The actuary has determined that over the same period they could have declared 0.5% three years ago, 1% two years ago and 1.5% last year using the compound approach. (iii) Determine the benefit amount for a single premium policy written three years ago with a sum assured of 10,000, under both approaches. [2] [Total 5] 2 A life insurance company is considering writing a new flexible unit-linked product targeted at high net worth individuals. The product allows flexibility in the amount of premiums payable and could be used either as a savings vehicle or to provide life cover, or a mixture of the two. The policyholder can invest in a range of different unit funds and switches can be made subject to charges. Annual fund management charges vary by fund. (i) (ii) Describe how the features of this product meet the needs of the target market. [3] Discuss the distribution channels that the company could use for this product. [13] [Total 16] 3 Describe the types of reinsurance that might be appropriate for the following: (i) Without profits decreasing term assurance. [6] (ii) Unit-linked endowment assurance. [2] (iii) A life insurance company which has a low level of solvency. [7] [Total 15] SA2 A2010 2

3 4 (i) Describe dynamic solvency testing. [5] A life insurance company has been established for many years and sells a wide range of protection, savings and annuity products. The company has an investment portfolio of 40% corporate bonds, 30% equities, 20% government bonds and 10% cash. The life insurance company has recently experienced the following: a reduction in sales of 25% of the previous year s level worsening lapse experience on its unit-linked savings portfolio, with lapse rates increasing from 6% p.a. to 10% p.a.; and a fall in equity markets of 25% and a fall in corporate bond prices of 30% (ii) Describe how these events are likely to have impacted the current solvency position of the company. [10] A director of the company has stated that he does not believe that the solvency position of the company will deteriorate any further in the next few years as the economic situation is bound to improve. (iii) Discuss the investigations that should be undertaken in response to this remark. [7] [Total 22] 5 A life insurance company writes only regular premium unit-linked endowment assurance contracts. The contracts provide a maturity benefit equal to the value of units at maturity, and a death benefit equal to the greater of the value of units on death and a guaranteed minimum monetary amount. The surrender value is the value of units. A surrender penalty is applied if the surrender occurs within the first ten years of the policy. Charges are deducted from the unit fund to cover expenses and the cost of providing the life cover. (i) State the principles that the company would consider when setting supervisory reserves. [7] (ii) Describe how the supervisory reserves may be calculated for these policies. [8] (iii) Suggest possible inadequacies in the production of the reserves, other than those related to methodology. [5] [Total 20] ST2 A PLEASE TURN OVER

4 6 A whole life assurance policy with a sum assured of 10,000 is to be issued to a person currently aged 60. The policy has an option such that at the fifth policy anniversary the policyholder may take out a further whole life policy for a sum assured of 10,000, at the company s standard premium rates and without evidence of health. Death benefits are paid at the end of the year and the mortality basis used is assumed not to change over time. Premiums are payable annually in advance. (i) Calculate the additional premium that should be paid for the option over the first five years of the contract, using the conventional method and assuming the following basis: Mortality: AM92 Select Interest: 4% per annum Expenses: None Lapses: None Tax: None [5] An analysis of industry data has shown that the mortality experience of those who take the option at age 65 is AM92 ULT plus 5 years added to the age, and the assumptions for those who do not take the option is AM92 ULT less 1 year deducted from the age. There is no data on the take up rates, but the company believes that the aggregate mortality remains at AM92 ULT. The company also believes that individuals make their decision whether to exercise the option based on their state of health at the option date. (ii) (iii) Calculate the additional premium that should be paid for the option, using the North American method. [7] Discuss the difference in the results between the conventional and North American methods. [5] (iv) Discuss how the company could manage the risk arising under the option. [5] [Total 22] END OF PAPER SA2 A2010 4

5 Faculty of Actuaries Institute of Actuaries EXAMINERS REPORT April 2010 Examinations Subject ST2 Life Insurance Specialist Technical 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. R D Muckart Chairman of the Board of Examiners July 2010 Comments These are given in italics at the end of each question. Faculty of Actuaries Institute of Actuaries

6 Subject ST2 (Life Insurance Specialist Technical) April 2010 Examiner s Report 1 (i) Simple: Bonus expressed as a percentage of the basic benefit. Compound: Bonus expressed as a percentage of the basic benefit plus any attaching bonuses. Super-compound: Bonus comprises two parts a bonus expressed as a percentage of the basic benefit plus a bonus expressed as a percentage of the attaching bonuses (bonuses previously declared). The bonus percentage declared on bonuses is usually higher than the bonus percentage declared on the basic benefit. (ii) (iii) Defers distribution of profit which can improve capital efficiency. The supercompound bonus method generally defers profit the most. Simple Approach: = 10,000 + (1% * 10,000 * 3) = 10, Compound approach: = 10,000 * ( %) * (1 + 1%) * ( %) = 10, This question was standard bookwork and was well answered by most candidates. 2 (i) The product allows flexibility in the premium payments which will allow the investor to be able to alter premiums to suit their income. For example the investor may receive irregular income or bonuses at certain times of the year which he wishes to invest. The product allows the investor freedom to invest in a variety of different types of investment with the freedom to switch between types of investment. This meets the needs of high net worth individuals who like the choice of funds. This will suit the financially sophisticated who want to be able to control their investments, and change their investments as their appetite for risk changes. It is also likely that the range of unit funds available will include some relatively high risk funds, which would meet the needs of this type of investor. The product is likely to be costly to run and so the charges are likely to be high. This will be acceptable to investors who expect to pay more for a more sophisticated product which is suited to their needs. Page 2

7 Subject ST2 (Life Insurance Specialist Technical) April 2010 Examiner s Report The product may be used for other purposes e.g. potential use in inheritance tax planning and ability to provide life assurance protection to family members. (ii) These are complicated contracts which will require careful explanation of the benefits and charges at point of sale. The product is aimed at high net worth individuals; it could be the case that these potential customers may in fact even initiate a sale. The company has the following options: Insurance intermediaries Insurance intermediaries (IFAs) are salespeople who must act independently of any particular life insurance company. Their aim is to find the best contract, in terms of benefits and premiums, for their clients. Usually they are remunerated, via commission payments, by the companies whose products they sell, but they may alternatively receive a fee from their clients. It will often be the client who initiates the sale. However, intermediaries are also likely to promote themselves actively to existing clients by, for example, instigating a periodic review of finances. This method of distribution would be a good choice for this contract since the intermediary has access to the type of target market at which the product is aimed and will have the expertise to ensure the customer understands the contract and makes the correct decision. As the IFA market is competitive the product will need to have terms comparable with competitors. Tied agents Tied agents are salespeople who are tied to one, or sometimes several, life insurance companies, that is they offer to their clients only the products of those companies. Typically they may be the employees of a bank or other similar financial institution. Where the tie is to more than one company, it will sometimes be the case that the product ranges of the companies are mutually exclusive, but more often there will be overlap. Page 3

8 Subject ST2 (Life Insurance Specialist Technical) April 2010 Examiner s Report Tied agents are remunerated by the companies to which they are tied. The remuneration could be in the form of commission payments or by salary plus bonuses. It will often be the client who will initiate the sale, but some tied agents may actively engage in selling. If the company already deals with tied agents then this method of distribution would be a good choice so long as the clients of the tied agents fit the target market. Own salesforce Members of the salesforce of a company will usually be employees of the life insurance company and hence will only sell the products of that company. They may be remunerated by commission or salary or a mixture of both. It will usually be the salesperson who initiates a sale, making use of client lists. However, once he or she has built up a rapport with a particular client, it will then often be the latter who initiates further sales. If the company employs its own salesforce then this is likely to be the logical solution. However, the target market at which this contract is aimed is unlikely to be on the existing client list as they are more likely to use a distribution method that gives them access to a wider range of product providers. Training will need to be provided to the salesforce as this is a complicated product. Direct marketing At present this takes four main forms: mailshots telephone selling press advertising internet selling The instigator of the sale varies depending on the method used. This is probably not a suitable method to use to distribute this product. Direct marketing is normally limited to simple products; here the complex nature of the contracts (the flexibility and charges) would require the product details to be explained in person. However it may be possible to generate initial interest in this product through direct marketing in carefully selected media (e.g. high quality newspapers). Page 4

9 Subject ST2 (Life Insurance Specialist Technical) April 2010 Examiner s Report This question was generally well answered although many candidates weren t able to elaborate or demonstrate a deeper level of knowledge to justify the answers they were giving. For example, not stating why high net worth individuals may have variable income and so flexibility over premium payment would be beneficial to them. In addition, many candidates didn t state which sales method would be the most appropriate and which would be inappropriate. Better candidates related the book work on sales channels to the question, rather than just providing the standard list of features of each sales channel. 3 (i) Without profits decreasing term assurance The product could be reinsured using original terms (also known as coinsurance). This method involves the sharing of all aspects of the original contract. The ceding company may supply the reinsurer with the premium rates it is using for the decreasing term assurance (DTA) it wishes to reinsure. In return the reinsurer will determine the level of reinsurance commission it is prepared to pay the company. Alternatively, the reinsurer may provide reinsurance rates to the ceding company on which it can load for profit and costs. There are two ways of specifying the amount to be reinsured, quota share and individual surplus. Under quota share a fixed proportion of each policy is reinsured, so for DTA the amount reinsured on a policy reduces over the term of the contract. For individual surplus the amount reinsured is the excess of the benefit over the ceding company s retention limit on an individual life. It will depend on the exact terms of the treaty in place, but for DTA this may mean that smaller policy sizes will not be reinsured if the retention limit is above the sum assured selected by the policyholder and that as the sum assured reduces over time the policy may no longer remain reinsured. Another method of reinsurance that could be used would be to use risk premium reinsurance. Risk premium reinsurance is where the ceding company reinsures part of the DTA sum assured with the reinsurer on the reinsurer s premium basis. The risk premium rates may be guaranteed or reviewable. As with original terms the amount reinsured may be determined on a quota share or individual surplus basis. Page 5

10 Subject ST2 (Life Insurance Specialist Technical) April 2010 Examiner s Report (ii) Unit-linked endowment assurance A company is unlikely to be able to gain reinsurance for the unit liability as the reinsurer would need to match the unit liability. Reinsurance could be obtained to protect a company against the mortality risk that would exist from the guaranteed sum assured under the product. Risk premium reinsurance is most likely to be used. The amount reinsured can be on a quota share basis or an individual surplus basis. (iii) An insurance company which has a low level of solvency The company may use financial reinsurance to quickly improve its low level of solvency. There are two primary types of financial reinsurance that can be used, asset enhancing and liability reduction. For asset enhancing, the reinsurer gives the company funds, with repayment contingent on the future emergence of the pricing and reserving margin, in the form of cash, over a given number of years. This increases the assets in the regulatory balance sheet, but has no impact on the amount of liabilities as repayment is contingent on the future emergence of the margins. There will be little to no change in the realistic accounts. Liability reduction is often known as virtual capital or time-deferred-stop-loss. The reinsurer agrees to cover a set amount of claims relating to policies of the longest term within the reinsured block of business. The company can then reduce its liabilities by the set amount and assets are marginally reduced, by the reinsurance fee. As the future margins emerge as cashflows over time the company recaptures the risk. Company X may also use other types of reinsurance (if it is not already) to increase its solvency level in the longer term. This would help to reduce total claim payouts, claim fluctuations and reduce new business strain. A company with low solvency would need to take particular care over its choice of reinsurer to minimise counterparty risk. Page 6

11 Subject ST2 (Life Insurance Specialist Technical) April 2010 Examiner s Report This question was relatively poorly answered despite being a bookwork type question. The better candidates recognised which types of reinsurance were appropriate, and gave valid reasons. These candidates scored better than those who purely listed all types of reinsurance, whether relevant or not, and did not consider the type of business in the questions. For example, better candidates recognised that a reinsurer could not cover the unit liability of unit-linked business. 4 (i) Dynamic solvency testing is the assessment of a life insurance company s future solvency position under a range of different economic and company specific circumstances. It involves projecting the life insurer s balance sheet and revenue account forward for a number of years and looking at the insurer s solvency position in each of those years. The projection needs to be for a sufficient period of years that the full effect of any potential risks may become apparent. In particular, the life insurance company s ability to withstand future changes (in both the external economic environment and the particular experience of the company) would be investigated. The projections could be done deterministically by stressing the relevant assumptions to test the effect of adverse future experience or the projections could be carried out using stochastic assumptions, with simulation to assess the level of probability of such adverse circumstances occurring (i.e. the probability of ruin). When carrying out dynamic solvency testing consideration has to be given as to whether to allow for new business or not in the projections. Assuming that the insurer is open to new business then allowing for new business is likely to give a more realistic assessment of the company s ability to withstand future adverse events. Analysis of the impact of new business would influence the company s new business strategy and future development plans. (ii) In terms of solvency position, assume that we are looking at the impact on the company s statutory free assets, i.e. on the statutory valuation basis including any solvency capital. Considering first of all how each of the events is likely to have impacted the current solvency position of the company: A reduction in sales of 25% of the previous year s levels: When written, new business normally causes capital strain due to high acquisition expenses and initial reserving and solvency capital requirements. Page 7

12 Subject ST2 (Life Insurance Specialist Technical) April 2010 Examiner s Report The fall in new business will therefore reduce this new business strain. However, the company may have experienced a change in the mix of business, e.g. a recession may lead to fewer policyholders taking out discretionary savings products. Hence whether the new business strain has actually fallen this year compared to the previous year will depend on the mix of business written. The reduction in sales is likely to increase the per policy expenses on the remaining business as costs are spread over a smaller book. This could contribute to a worsening solvency position. Worsening lapse experience on its unit-linked savings portfolio: It is not clear to what extent the company has to hold statutory non-unit reserves and solvency capital for these unit-linked savings contracts. This will depend on the local regulations depending on which country the life insurance company operates in. The worsening lapse experience will result in higher statutory reserves and solvency capital being released than expected if the surrender values paid are less than the total of unit reserve, non-unit reserve and solvency capital. In addition there may be a knock-on impact that, due to the higher lapses, the per policy expenses on the remaining business may increase, which could contribute to a worsening solvency position. A fall in equity markets of 25% and in corporate bond prices of 30%: We are told that the company is invested 40% in corporate bonds and 30% in equities and assuming that the company is widely diversified and hence experiences the same losses as the overall market, then the market value of the company s assets has fallen by [(40% 0.3) + (30% 0.25) = 12% + 7.5% = approx. 19.5% (ignoring any change in value of the government bonds). Unit reserves will reduce but this will be offset by a reduction in backing assets. The statutory reserves may be valued using the yields derived from the underlying portfolio of assets held. The fall in corporate bond prices means that the yield on corporate bonds has increased, as has the dividend yield on equities. The rise in corporate bond yields will result in a rise in the valuation interest rate which will reduce the liabilities. Whilst the valuation interest rate may increase, due to the increased yields on the equity and corporate bond assets, it is unlikely to increase to the same extent as the actually increase in the yields. Page 8

13 Subject ST2 (Life Insurance Specialist Technical) April 2010 Examiner s Report Hence the statutory value of the liabilities may fall, but not by as much as the fall in the value of the assets. The relative impact also depends on the degree to which statutory liabilities and assets are matched by term. If the solvency capital is defined as a % of statutory reserves, solvency capital may also fall. The future fee income expected on the unit-linked savings business will have fallen dramatically as a result of the fall in the equity and corporate bond markets. If this future fee income is allowed for in the calculation of the non-unit reserves then the drop in expected future fee income (due to the lower unit fund values) is likely to lead to an increase in the non-unit reserves (or a reduction in negative non-unit reserves). The cost of guarantees is also likely to have increased as a result of the falls in asset values. It seems likely that overall, the fall in equity markets and corporate bond markets, is likely to have significantly worsened the overall solvency position of the company. General comments Whilst it is not possible to know for sure the overall impact on the solvency position of the life insurer, the fall in the asset markets seems most likely to be the event that drives the overall impact on the company. Although this impact may be mitigated to some extent by actions taken by the management. The first two events impact the level of one year s worth of new business (which is likely to be a small impact in relation to the size of the in-force book for a well established insurer) and the level of lapses on one part of the product portfolio. It should be recognised that lower sales does not automatically mean that the company s solvency position will have improved. This depends on the balance between the level of new business strain and the surpluses being released from existing business, and the extent that any new business strain is mitigated by reinsurance financing. But overall it seems likely that the solvency position of the company will have worsened as a result of the combination of the three events mentioned. (iii) Although it is possible that the situation will improve, this is not guaranteed and there may be future deterioration in experience. Page 9

14 Subject ST2 (Life Insurance Specialist Technical) April 2010 Examiner s Report The life insurer has a responsibility to ensure that it remains solvent in all possible foreseeable events. And the local regulator is likely to also want the company to be able to demonstrate that it will remain solvent in all possible foreseeable events. Dynamic solvency testing is particularly useful in this context, especially where stochastic simulations are used, with probability weights attached to each stochastic projection, since this will provide the insurer with insight into the future solvency position of the company in a range of what if scenarios. Hence the insurer can investigate what would happen to the projected solvency position of the company in a range of economic scenarios. This would include a wide variety of scenarios such as: A scenario similar to the one that the marketing director anticipates, where equity and corporate bond prices revive, sales volumes return to more normal levels and lapses return to the long term assumed levels. Whilst interesting, this is likely to be the best case scenario. A scenario where conditions continue to worsen where one or more of the following scenarios are included sales volumes continue to deteriorate, continued change in mix of business, continued deterioration in persistency or further falls in stock markets A number of different versions of this scenario are likely to be tested e.g. specific shock events (1 day fall in stock market of further 20%), long term steady deterioration etc. The recent events might have resulted in the company changing its views of constitutes a reasonable adverse scenario, particularly if the actual events were worse than those previously anticipated. If the company does its dynamic solvency testing stochastically then it will have to recalibrate its economic assumptions to the current conditions, which may for example have higher volatility than previously. The insurer will project the balance sheet and the income statement for a number of years under each of these economic scenarios. The company will be able to analyse the impact on its solvency position in each future time period. The insurer may explore the impact of each event separately initially, and then combinations of events, to better understand the knock on possible impact of a number of events occurring at the same time. The insurer will be able to explore how it could improve its solvency position in certain events by considering the management actions that it could take in response to certain events e.g. reducing bonuses/crediting rates, increasing mortality charges, increasing AMC s/policy fees etc. Page 10

15 Subject ST2 (Life Insurance Specialist Technical) April 2010 Examiner s Report In extremely negative scenarios, the insurer may want to consider the impact of more strategic events, such as closing particular lines of business or distribution channels, changing the business mix significantly, introducing new low-cost distribution channels, stopping sales in particular geographic regions etc. The investigations should be updated frequently (especially during times of uncertainty), such that the Board of Directors can use the information to monitor the solvency position of the company. Investigations should be made into the reasons behind the movements and potential impacts on expectations of the future. This could include seeking expert external opinions. This question was poorly answered. Part (i) was bookwork but many candidates missed out on basic points. In part (ii) the better candidates discussed the impact of reduced sales on both NB strain and future expenses. For increases in lapses they recognised that the company would have been holding a reserve; poorer candidates did not consider this and purely considered the outgo from the surrender. For the market fall part of the question a number of candidates failed to consider the impact on both assets and liabilities. Better candidates also included comments on the level of matching and the impact on non-unit reserves. Part (iii) was poorly answered by many candidates and only the exceptional candidates recognised the need to use dynamic solvency testing, despite it being the subject of the first two parts of the question. 5 (i) The reserves should be sufficient to meet all liabilities arising out of the contract. The reserves should be calculated by a suitably prudent actuarial approach. The reserve should be at least as great as the guaranteed surrender value (i.e. the face value of units). Non-unit reserves should be held. The reserves should cover future expenses, including commission. The reserves should take credit for premiums due to be paid under the terms of each policy. A prudent valuation is not a best estimate valuation and should include appropriate margin for adverse deviation of the relevant factors. Valuation should take account of nature, term and method of valuation of corresponding assets. Use of appropriate approximations and generalisations is allowed. Page 11

16 Subject ST2 (Life Insurance Specialist Technical) April 2010 Examiner s Report Valuation rate of interest for the non-unit reserve should be chosen prudently taking into account currency of policy and having regards for yields on corresponding existing assets and yield expected to be obtained on sums invested in the future. Demographic and persistency assumptions should have regard to type of business and country of residence. Method should recognise profit in an appropriate way. The method should not be subject to discontinuities arising from arbitrary changes to the valuation basis. Method and bases should be disclosed. (ii) The reserve will comprise two components: a unit reserve and non-unit reserve. Unit reserve equal to the value of units held at the valuation date. As the contract has surrender penalties the company could use actuarial funding to hold reserves less than unit value. Consider year-by-year (or month-by-month) occurrence of non-unit related cashflows. Project forward unit reserves including allowance for allocated premiums, fund charges, investment return etc Project forward non-unit cashflows on reserving basis allowing for the following items: charges received (AMCs, policy fees) bid/offer spread expenses expected to be incurred in the future commission expected to be paid mortality charges received expected death claims in excess of the unit fund surrender penalties Perform projections on a policy-by-policy basis and start with last projection period in which net cash flow becomes negative. Amount set up at start of this period sufficient to zeroise negative cashflows, after allowing for earned investment return over the period. This amount is then deducted from the net cash flow at the end of the previous time period. Page 12

17 Subject ST2 (Life Insurance Specialist Technical) April 2010 Examiner s Report The process continues to work backwards towards valuation date with each negative being zeroised. If adjusted cash flow at the valuation date is negative then a non-unit reserve is set up equal to this absolute amount. As there are surrender penalties it may be permissible to hold negative nonunit reserves, subject to certain other conditions being met. For example, total reserve should be greater than or equal to the surrender value. Ensure that the relevant reporting regulations of the local country are met and hold a mismatch reserve if required. (iii) Data May be valuing cancelled policies in error. May be missing some policies. Inadequate/incomplete policy data e.g. premiums, maturity date, age etc. Data errors (e.g. decimal point in wrong place when input). Unit reserve incorrect due to unit pricing error. Reinsured business incorrectly allowed for (e.g. incorrectly marked as reinsured or the treatment of the reinsurance in the valuation does not reflect the actual treaty). Using rolled forward rather than actual data, due to reporting deadline pressures. Assumptions Valuation basis not prudent enough or may be excessively prudent. Demographic assumptions may not reflect latest expected future experience of business. Valuation interest rate may not reflect assets backing the business. Assumptions may not allow for known future changes e.g. expenses. Surrender assumptions may not reflect impact of surrender penalties. Other Potential calculation errors in any manual reserves or using inappropriate approximations. Page 13

18 Subject ST2 (Life Insurance Specialist Technical) April 2010 Examiner s Report Errors in automated valuation systems, e.g. due to lack of testing. Basis may not be documented adequately. Not keeping up with guidance/regulatory changes. Model not including all relevant product features. Part( i) was bookwork which was generally well answered although key items of the bookwork were missed by many candidates. In part (ii) candidates who could logically describe how a non-unit reserve was calculated scored well, although many candidates failed to mention that a unit reserve needed to be calculated and projected. Part (iii) was poorly answered, many candidates focused on one area rather than thinking widely. For example, considering many types of problems with assumptions but not considering issues with data or models. 6 (i) Using the conventional method, the information we require is: A [60] = A 65 = ä [60] = ä 65 = D [60] = D 65 = ä [60]:5 = A [65] = ä [65] = The expected present value of the benefit is: EPV(B) = 10,000*(A [60] +D 65 /D [60] *A 65 ) = 10,000*( /880.56* ) = The expected value of premium income is: EPV(P) = P(A [60] ) ä [60] + P(A [65] )* D 65 /D [60] * ä 65 P(A [60] ) = 10,000*A [60] / ä [60] = 10,000* / = P(A [65] ) = 10,000*A [65] / ä [65] = 10,000* / = * *689.23/880.56* = So the expected present value of the option is = Credit was given if candidates approached this part by taking the value of the difference in the theoretical premium less actual i.e. P(A65) = 430 and so: ( )*12.276*689.23/ = Page 14

19 Subject ST2 (Life Insurance Specialist Technical) April 2010 Examiner s Report This must equal the expected present value of the extra premium to cover the option cost, so: P(extra) ä[60]:5 = (or if used unrounded numbers) P(extra) = 38.90/4.559 = 8.53 (or 8.51 if used unrounded numbers) Where candidates used different methods, appropriate credit was given provided full workings were shown. (ii) One way of determining the take up rate is to calculate the rate required such that the ultimate mortality at age 65 can be derived from the assumed rates for healthy and unhealthy lives. The ultimate mortality rate at 65 = The rate of those who take the option = The rate of those who do not take the option 65 1 = Assuming 100% of those who would benefit from the option will take the option, we can equate the percentage (x) that take the option from the following equation: x * (1 x) * = so x = Other methods were given credit provided full workings and assumptions were shown. Using the North American method: The expected present value of the cost of providing the option is the expected present value of the benefits less the expected present value of the premiums. The additional information we need is: A' 65 = A 70 = ä' 65 = ä 70 = The expected present value of the benefits is: EPV(B) = 10,000*(A [60] * D 65 /D [60] *A' 65 ) EPV(B) = 10,000*( * / * ) = Page 15

20 Subject ST2 (Life Insurance Specialist Technical) April 2010 Examiner s Report The expected present value of the premiums (excluding the extra premium) is: EPV(P) = * ä [60] + D 65 /D [60] *0.1265* ä' 65 * = * /880.56* *10.375* = The expected present value of the additional cost of the option is therefore: 5, ,988.7 = Credit was also given where the value of the premiums saved was calculated instead, i.e. 10,000*A 70 / ä 70 = 10,000* / = * ( )* * / = P(extra) * ä [60]:5 = P(extra) = 157.5/4.559 = Credit was also given if candidates followed the approach of disaggregating the contract fully from year 5 then give relevant marks for the workings. The answer would be different but valid: EPV(B) = 10,000*( /880.56* ) + (0.1265*20000* ( )* *10000) * / = EPV(P) = *( /880.56*(10.375* ( )*12.653)) *689.3/880.56*.1265* = So option = Note it is important that the candidate recognised that the total mortality post year 5 is ultimate and does not assume that those not taken the option are ultimate on their own. (iii) The North American method gives a significantly higher cost than the conventional method. There will be an impact for the fact that the assumed take up rate is based on the q at age 65 whereas the costs include valuing benefits using mortality for the rest of life, and the proportion with higher mortality would not remain at this fixed level. However this is unlikely to be the main reason. The key reasons that the cost for the conventional method is lower is because there is the assumption that 100% of policyholders take the option and the assumed mortality is different. Those with healthier lives have mortality rates which are lower than those assumed in the new policy pricing basis, even allowing for the selection allowance in the pricing. These policyholders are paying more than the cost of their benefits and so are subsidising the policyholders in ill health. Page 16

21 Subject ST2 (Life Insurance Specialist Technical) April 2010 Examiner s Report It is unlikely that these policyholders could get special rates on the market due to them having slightly lower mortality than the select rates imply, and so they may well take the option. However, since they could get standard rates based on select mortality in any case, it is optimistic to assume that 100% would take the option. Therefore the cost based on the conventional method is likely to be too low. (iv) The insurer should adopt continual monitoring and review of the benefits of options versus their costs. At an objective level, the insurer should seek to monitor the charges/loadings included for options in the product pricing with the actual costs being experienced. The analysis should look separately at both the uptake rate for the option and the profit or loss which arises once an option is exercised. Mortality experience analyses should be performed looking at those who take the options and those who don t as well as looking at the combined experience. If these assessments show that the continued availability of the option, even allowing for a subjective assessment of the increased marketability which the option brings, carries a net loss for the insurer then the option s pricing should be increased and/or its availability should be reduced or removed altogether. The time lag between removal of an option and the impact on experience emerging must be borne in mind. It is easier, legally, to amend suitably the terms of new business written. It may also be possible to reduce the impact of options under existing business by a strict interpretation of policy literature, subject always to the interpretation satisfying policyholders reasonable expectations. The company could also ensure that initial underwriting is appropriately strict, taking into account the potential future option. The company may use reinsurance to manage the overall risk, although the reinsurer will include charges to reflect the uncertainty regarding the option. The company could add margins in both the pricing of the option and the valuation bases until adequate data is determined. The answers to this question were very mixed. Candidates generally answered part (i) well but struggled with the other parts. Marks were awarded for all valid approaches. Many students lost marks for looking up incorrect values from the actuarial tables, however follow through marks were awarded if this was the only mistake. In part (ii) many candidates lost marks for using a too simplified approach for the take-up assumption. Parts (iii) and (iv) Page 17

22 Subject ST2 (Life Insurance Specialist Technical) April 2010 Examiner s Report were poorly answered. Many candidates in part (iii) purely stated the difference between the two approaches but did not expand wider to consider points such as healthy policyholders cross-subsidising those in ill-health. In part (iv) most candidates mentioned reinsurance and underwriting but only the better candidates considered performing experience analyses for take-up and mortality, and reviewing the rates following such reviews. END OF EXAMINERS REPORT Page 18

23 Faculty of Actuaries Institute of Actuaries EXAMINATION 4 October 2010 (pm) Subject ST2 Life 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 before 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 six 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 from the approved list. ST2 S2010 Faculty of Actuaries Institute of Actuaries

24 1 A life insurance company operates a number of internal unit-linked funds. Unit prices are calculated daily. All the funds are expanding, and therefore are priced on an offer basis. (i) (ii) Explain the basic equity principle as it applies to the pricing of an internal unit-linked fund. [3] Describe how this principle is applied when determining the appropriation and expropriation prices for a fund. [3] The following details are for the Equity Fund as at the end of 31 March Market value of assets (excluding cash) within the fund = 50,000 Cash balance in the fund = 750 Number of units = 10,000 Selling costs of assets in the fund = 1,376 Purchasing costs of assets in the fund = 1,152 The market value and cash balances allow for current assets and liabilities of the fund, and any accrued income or tax adjustments. There is an initial charge of 3% and all offer and bid prices are rounded to three decimal places. Prices are calculated at the end of 31 March 2010, and applied to new requests for investments or disinvestments received during that day. (iii) Calculate the following in relation to this fund, stating any assumptions: (a) (b) (c) (d) (e) Appropriation Price Expropriation Price Offer Price Bid Price Number of units purchased by a new investment of 1,500 received on 31 March 2010 [6] [Total 12] ST2 S2010 2

25 2 A life insurance company has recently started selling a regular premium unit-linked endowment assurance product. The death benefit is the maximum of the total premiums payable over the lifetime of the policy and the bid value of units. This benefit is charged for by a monthly deduction of units based on the sum at risk each month. In the past a similar contract was offered, with the exception that the death benefit was the bid value of units. It is proposed that policyholders with this older version should be offered the opportunity to add the same minimum life cover to their policy as is provided under the new version of the product. Discuss the factors that the company would need to consider before adopting this proposal. [9] 3 A life insurance company has written unit-linked single premium bonds for a number of years. The company is expanding into the unitised with profits bond market. Regular bonuses would be added annually and may be zero but never negative. (i) (ii) Describe the alternative approaches for applying the regular bonuses to the unitised with profits bond. [4] Discuss the product features and assumptions which the company would need to consider for the launch of the new bond. [10] [Total 14] 4 A life insurance company has sold a wide range of life insurance products through independent intermediaries for many years. A proposed change in legislation means that it will no longer be attractive to sell solely through this channel. The life insurance company is considering setting up a direct sales force. Discuss the issues that the company should consider in setting up a direct sales force. [15] 5 A life insurance company sells non-reviewable conventional without profits term assurances and individual unit-linked endowment assurances. (i) Outline the features of these products. [8] (ii) Describe the main risks to the policyholder of purchasing each of these products. [6] (iii) Discuss the risks to the life insurance company of selling these products. [14] [Total 28] ST2 S PLEASE TURN OVER

26 6 A life insurance company sells conventional with profits endowment assurance policies. It has 15,000 of these policies in-force at the very start of the year and sells a further 2,000 new policies on the first day of the year. The features of the business are as follows: Cohort Number of policies Average individual asset share at the start of the year Average per policy sum assured plus attaching reversionary bonus Average per policy terminal bonus payable on death Expected death rates based on 100% mortality table X Average premium per policy (annually in advance) Number of deaths occurring at the end of the year A 10,000 $5,000 $5,000 $1, $ B 5,000 $4,000 $4,500 $1, $ C (New business) 2,000 $0 $3,500 $ $700 5 All premiums are received on the first day of the year. During the year the investment income (net of investment expenses) on the assets backing the asset shares totalled $4.3 million. Total acquisition expenses incurred in the year were $1.5 million. Total maintenance expenses were $510,000 payable annually in advance and allocated to both in-force and new business. Commission is 2% of every premium. Deaths occur at the end of the year but before the declaration of any regular bonuses. There were no surrenders or maturities during the year. The company pays no tax. The company pays shareholder transfers at the end of the year of one ninth of any terminal bonuses paid during the year plus one ninth of the cost of the declared bonuses added to policies in-force at the end of the year (after any deaths that occur). The company declared a regular reversionary bonus at the year end at a rate such that the cost, before any shareholder transfers, was 4% of the existing sum assured plus attaching reversionary bonus. (i) Calculate the total aggregate asset shares at the year end for the whole portfolio, explaining your approach. [5] ST2 S2010 4

27 The company calculates individual policy asset shares using actual death rates applied to the asset shares, where the death rates are taken from mortality table X and multiplied by a factor F. The factor F is based on total actual deaths divided by total expected deaths assuming 100% of mortality table X. (ii) Show that factor F is equal to [2] (iii) Calculate the individual asset share for an average policy within cohorts A and C, explaining your approach. [8] The individual asset share for an average policy within cohort B is $4,782. (iv) Discuss the difference between the aggregate asset shares and the sum of the individual asset shares. [7] [Total 22] END OF PAPER ST2 S2010 5

28 INSTITUTE AND FACULTY OF ACTUARIES EXAMINERS REPORT September 2010 examinations Subject ST2 Life Insurance Specialist Technical 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. T J Birse Chairman of the Board of Examiners January 2010 Institute and Faculty of Actuaries

29 Subject ST2 (Life Insurance Specialist Technical) September 2010 Examiners Report 1 (i) Basic Equity Principle For unit holders the only prices relevant are those at which they buy units in the fund and those at which they redeem their units. In theory, the movement in price between those two events should only reflect the performance of the assets backing the unit and charges deductible under the policy provisions. Price should not be affected by creation or cancellation of other units, otherwise cross subsidies between unit holders will arise. The basic equity principle of unit pricing for an internal fund is therefore that the interests of unit holders not involved in a unit transaction should be unaffected by that transaction. (ii) The basic equity principle is only achievable if the amount of money put into the fund, or taken out of the fund, is such that the net asset value per unit is the same before or after appropriation. Appropriation price is this amount of money when creating a unit. It preserves the interests of existing policyholders. Expropriation price is this amount of money when cancelling a unit. It preserves the interests of continuing policyholders. (iii) (a) Appropriation Price MV of assets (excluding cash) 50, Cash Balance , Total fund value = Market value of assets + purchasing costs of assets = 50, ,152 = 51,902 Number of units = 10,000 Appropriation Price = per unit (b) Expropriation Price Deduct sales costs from appropriation price total fund value Fund value = 50,750 1,376 = 49,374 Expropriation Price = per unit Page 2

30 Subject ST2 (Life Insurance Specialist Technical) September 2010 Examiners Report (c) Offer price Assumes continuing on an offer basis Offer price = appropriation price plus initial charge Initial charge of 3% Offer Price = / 0.97 = Rounded to 3dps = (d) Bid Price On offer basis, bid price = appropriation price Rounded to 3dp Bid Price = (e) Units purchased by 1,500 Offer price used for purchases 1,500 / = units Part (i) candidates were able to state the basic equity principle but given the number of marks available few expanded upon this. In part (ii), a common mistake was to provide a description of the appropriation and expropriation prices and how they are calculated rather than answering the question and relating that back to the basic equity principle. Part (iii) was well answered although some candidates were confused as to how the selling and purchasing costs affect the appropriation and expropriation prices. 2 The proposal impacts existing business only, so the motivation needs to be understood. It may have been proposed in order to reduce lapses, either to the new product or to competitors. Under the original policy, the only mortality risk to the company was that initial expenses may not have been recouped on early death. The product design would not have encouraged any anti-selection with regard to mortality. As a result, it is highly unlikely that any underwriting would have been carried out at the point of sale. For the new product, the additional life cover is an integral part of the product, which is largely used as a savings vehicle, and so there is likely to be little anti-selection from new policyholders. For the policyholders with the old version, it is likely to be the less healthy that take up the offer. Alternatively the demographics of the policyholders with the old version of the product may be different to the new version. If the company intends to charge a different (i.e. higher) base level of mortality deductions than those under the new version, to allow for any anti-selection risk or Page 3

31 Subject ST2 (Life Insurance Specialist Technical) September 2010 Examiners Report differences in demographics, then it needs to consider any potential adverse impact arising from this, such as reputational damage. Underwriting should also be carried out where the potential sum at risk is high. In assessing this, the company should consider potential falls in unit values. The company needs to consider how the cost of underwriting would be recouped. The company should accept that there are likely to be a higher level of rated and rejected cases. This may cause brand damage having written and offered the option to those policyholders. The mortality deductions from the fund will lead to lower maturity values compared to before. Or the premiums could be increased to target a similar maturity value. In the latter case, it would alter the minimum sum assured. Clear communications (including projections) to policyholders will be required to inform policyholders of the changes in potential maturity value or the level of premium. The company would need to consider whether the reduction in fund will lead to reduced charges for the company (e.g. reduced annual management charges.), which could lead to reduced profit or non-recovery of expenses or whether the mortality charges include a profit loading that would mitigate this. If the company does not offer the option then there is a lapse and re-entry risk. The most benefit from the option would be early in the policy term when the fund value is low. However, surrendering at this time would possibly incur surrender penalties. Ease of administering the proposal is important. For example, if the two products are administered on the same system it may be relatively simple. If the development cost was significant, it is unlikely to be in the company s interest to make this offer. Also if the take up rate for the option due to lack of perceived benefit to the policyholder is expected to be low, resulting in low volumes, then the development costs my not be recouped. Impacts on reserving levels and capital requirements would need to be taken into account. An analysis of the potential overall impact on profits would be required. Page 4

32 Subject ST2 (Life Insurance Specialist Technical) September 2010 Examiners Report The sensitivity of profit may also be investigated as would any changes in the risk profile. There may be regulatory requirements to take into account when amending a policy (e.g. ensuring that the charges and underwriting proposals treat customers fairly). If the likely overall sum at risk on the converted business is high then the company might want to consider reinsurance, and so the proposal would have to be discussed with reinsurers. This question was generally poorly answered, many candidates did not properly understand the guarantee being applied to the contract and did not discuss the additional charges that the company would take and the impact that they would have on the expected maturity value 3 (i) Additional units approach The unit price remains constant. The company allocates additional units to each contract at the bonus declaration date, this could be using a compound or super-compound approach. The number of bonus units is determined at the discretion of the company. Bonus units added may be zero but units will not be taken away. Unit price approach No additional units are allocated. The price of a unit changes to reflect the bonus addition. The level of the movement in the unit price is at the discretion of the company. The change may be zero but will not be negative. (ii) Product Features The company needs to consider whether the UWP contract is to be offered as a stand alone product, or as an option within the existing unit-linked bond. The company needs to consider how regular bonuses will be added to the policy, either through addition to units or by changing the unit price and on the split between reversionary and terminal bonus. A scale of surrender penalties will need to be determined, and the company may decide to use the existing scale for the unit linked bond and amend if appropriate. The company must decide whether any terminal bonus should be included on surrender and if so, from which point in the term of the policy. The company is likely to introduce the right to apply Market Value Reductions (MVRs) to the face value of units. The size of the MVR will be at the discretion of the company. The company might consider offering one or more no-mvr guarantee dates, e.g. on the tenth policy anniversary. Page 5

33 Subject ST2 (Life Insurance Specialist Technical) September 2010 Examiners Report The death benefit should be defined, e.g. return of fund value. The company might guarantee that no MVR will be applied on death. The company will need to decide if the death benefit should include any extra element of terminal bonus. If no terminal bonus is paid on death and/or surrender then the company would need to consider how it ensures that policyholders are treated fairly regarding the regular bonus allocation. Charges could remain in current format as those applied to the unit-linked version of the bond, or the company could take charges implicitly through bonus rates. The company may need to review level of charges if any experience assumptions have changed. The company would need to consider how to treat increments/top ups. The company would need to consider whether it was going to alter the maximum and minimum limits, for example on premiums, ages or terms. When considering the product features to offer the company would also need to consider the product features offered by its competitors. The product feature may be restricted by the ability to incorporate them on the company s administration system. Assumptions Investment growth assumptions will differ from the unit-linked version as it will depend on the mix of with profits assets chosen. A stochastic investment model is required if any no-mvr guarantee dates are given. Lapse rates will need to be reviewed. The bond is likely to appeal to a different target market so different experience may be expected. The company will need to allow for the impact that the change in surrender penalties will have on lapse rates. The company also has to consider selective lapses if a no-mvr guarantee date is given. Expenses may differ from the unit-linked version of the contract. Page 6

34 Subject ST2 (Life Insurance Specialist Technical) September 2010 Examiners Report The ability of the charges to recover development expenses would also need to be considered. The company would need to reconsider its assumptions regarding the level of new business volumes and new business mix to review the recoverability of expenses. The company may need to review the expense inflation assumption too. The company needs to decide what level of commission to pay. Mortality is unlikely to be materially changed from the unit-linked version. The company would need to reconsider its assumptions regarding the level of new business volumes and new business mix to review the recoverability of expenses. Part (i) was reasonably well answered. In part (ii), answers tended to be generic rather than focusing on the specific product features of a unitised with-profits product. Better candidates were able to demonstrate an understanding of the contract and describe the product features well such as death and surrender benefits and details regarding how an MVR might be applied. 4 General information on existing DSFs First of all the insurer will consider whether DSFs are already common in the market place and the portion of total sales of life policies sold through DSFs compared to other channels by their competitors. If DSFs are already quite common and well established, analysis will be carried out on the competitors sales forces, such as collecting details about the size of the sales forces, the branch networks/coverage of each geographical area, and the level of sales achieved by those sales forces. The insurer may be able to get statistics from an industry body relating to the productivity of direct sales forces in the market. The company would also want to decide upon the size of the direct sales force required. Consider how other companies, who currently only sell through independent intermediaries, will react and the impact this will have on company s ability to develop a direct sales force. Costs In order to understand the costs of having a DSF, the life insurer will need to consider both the initial development costs and those that will be incurred on an ongoing basis. Page 7

35 Subject ST2 (Life Insurance Specialist Technical) September 2010 Examiners Report The following will be important: The management structure used to manage the DSF e.g. number of agents to a supervisor, the number of supervisors to a branch manager, the number of branch managers to an area manager and so on. The level of infrastructure maintained by competitors e.g. size and location of branches (whether high street or not), type of working (e.g. sales agents may mainly be on the road with the branches providing flexible office space for a small proportion of the total number of agents at the branch), the facilities at the branches and provided to the DSF. Whether any basic fixed salary is paid to the DSF (the sales people and the different layers of managers). Level of productivity measured by number of policies sold per month, average premium income collected each month. Average variable commission earned per sales agent per month. The level and types of incentive schemes used by the competitors to incentivise performance e.g. membership of special high performer clubs, competitions, perks on achieving certain sales levels. The life insurer will need to consider how sales agents will be recruited and trained. In particular, the insurer will need to consider what proportion of those hired will actually turn out to be productive agents. Recruitment and training costs may be significant and the insurer will need to factor this into the overall costs of establishing a DSF. Training costs may be heavily influenced by local regulations e.g. there may be a requirement for each sales agent to receive x hours training, or to pass certain exams before they are able to sell to the general public. These mandatory training costs need to be taken into account. Similarly there may be compliance regulations, such as carrying out background checks at the recruitment stage, that also need to be taken into account. There may also be higher ongoing costs in relation to the DSF due to more onerous regulatory requirements, which would need to be understood thoroughly. Having assessed the potential development costs, the insurer will need to consider whether it has the capital (or access to the capital) to establish a DSF. In particular, the level of capital required may limit the geographical coverage that the company can achieve or could perhaps limit the number of branches it can afford to establish initially. The life insurer will also want to consider whether to do things differently to its competitors e.g. it may decide to only establish super-branches in key cities, with most DSF agents working from home. The life insurer will also need to decide how it will solicit leads in the first place e.g. through the establishment of a tele-sales unit, since these factors will influence the infrastructure costs. Page 8

36 Subject ST2 (Life Insurance Specialist Technical) September 2010 Examiners Report The life insurer may be able to save some costs by having less underwriting on the business sold by the direct sale force compared to insurance intermediaries. Impact on existing sales channels and quality of business The DSF may target a different socio-economic class than the existing intermediary channel. If this is the case then the insurer will want to consider whether to launch a specific range of products aimed at this sales channel e.g. with lower sums assured, lower minimum premiums etc. Different socio-economic classes generally tend to exhibit different levels of experience, for example, mortality, different lapse rates, possibly different increment rates. Also, higher margins may be required in the pricing assumptions due to the uncertainty in the assumptions as this is a new product to the company. Hence in order to be able to offer products that are competitive to the existing intermediary channel it may be necessary to launch separately priced products. The administration system may need to be changed in order to allow for the differential pricing. The size of policies written by the direct sales force may be smaller, which may impact any cross-subsidies previously allowed for. The life insurer will be particularly keen to understand what its competitors have done in this regard e.g. whether they have launched differentiated products for this sales channel and also whether there are any industry statistics e.g. that demonstrate the different lapse rates experienced by different sales channels. The life insurer will want to ensure that there is no detrimental impact on its existing business from the intermediary channel. In particular, it will be important to ensure that the intermediary channel does not see the DSF as a threat to its own business. This issue may be largely solved through targeting a different socio-economic class of policyholders, different geographic regions, possibly where the intermediary channel is not so strong etc. Risks There are specific risks associated with setting up a DSF, the most important being mis-selling risks. In some markets in the past, when DSFs were common, insurers have been charged significant sums of money for failing to demonstrate that their products were well and fairly sold and that the customer understood the product at the time it was purchased. Mis-selling risk can only be reduced by ensuring that compliance procedures are tight e.g. in terms of the paperwork that has to be filled in when a sale is made, and through regular auditing to ensure that those compliance procedures are followed. Other risks can be mitigated by aligning policyholder and sales force interests such as reviewing the commission structure to encourage persistency. Page 9

37 Subject ST2 (Life Insurance Specialist Technical) September 2010 Examiners Report However, given that most mis-selling scandals only became scandals many years after the sales were made due to a wide variety of factors (consumer pressure, legal and political environment etc), it is impossible to totally remove mis-selling risk. DSFs have the ability to ruin an insurer s reputation, since the DSF becomes the face of the insurance company and will be the first point of contact for most customers. Hence there is a high degree of reputational risk at stake in establishing a DSF. The life insurer may want to consider the reputation of competitors DSFs and what those companies have done to achieve those good or bad reputations. One of the key risks is that the life insurer fails to establish its DSF well and that the DSF is insufficiently productive. This could lead to the DSF closing after a short period. This is a real risk due to the high cost of establishing a DSF (e.g. establishing a branch network) low volumes sold would not recover these costs. Setting up a DSF is also difficult without prior experience. One way to mitigate this risk would be to hire in expertise e.g. recruiting a new sales director from a competitor with a well established DSF. Other The life insurer will consider whether there are any incentives to set up such a sales channel e.g. tax incentives. The company may also consider buying a direct sales force rather than trying to establish one from scratch. The company would also compare setting up the direct sales force with other alternative options, such as tied agents or direct marketing. Generally well answered, though many candidates did not adequately describe items such as geographical coverage, analysis of competitor direct sales forces and limitations of capital on plans to set up the DSF. A common mistake made by candidates was to spend time describing direct sales forces and insurance intermediaries rather than answering the question being asked. 5 (i) Product features For both products single or regular premiums could be paid and contracts could be on a single or joint life basis. Term assurance The benefit is payable on death of the life assured, within the term of the contract. There is no surrender value payable under the contract and the contract expires if the required premiums are not paid. Page 10

38 Subject ST2 (Life Insurance Specialist Technical) September 2010 Examiners Report The benefit can be level or decreasing through the term, once chosen at outset, the insurer cannot alter the benefit or premiums paid by the policyholder. The contract can be used to provide protection against the financial loss of the death of a key person or can be used to provide a benefit on death to cover the outstanding balance on a loan. The group equivalent of the contract can be used by an employer to provide benefits to an employee s dependants upon the employee s death. The convertible form of the contract allows policyholders to convert their policy to an endowment or whole of life contract, or to renew their existing contract. Conversion or renewal would be without the need for further medical evidence. Unit-Linked Endowment The benefit is payable on survival to the end of the term of the contract, chosen at outset. A benefit is also provided if death occurs within the term of the contract. A surrender value would be payable within the term of the contract, subject to a possible surrender penalty in the early years. The level of the benefit payable on survival to the end of contract would be dependant upon the value of units held in a number of unit-linked funds. The level of the benefit payable on death tends to be a fixed monetary amount or the value of the units held, if higher. Charges to cover the cost of any life cover and expenses can be taken from the premium before being used to purchase units or deducted from units already purchased. The charges can be guaranteed or reviewable. The policyholder can select which fund or funds to invest in and can switch between different funds. Premiums payable by the policyholder can be flexible. The product can be used to cover an interest only mortgage. (ii) Risks to the policyholder in purchasing the product Either product There is a risk that the insurer may become insolvent and the dependants may not receive the full benefit. There is a potential mis-selling risk that the policyholder did not understand what they were buying. Page 11

39 Subject ST2 (Life Insurance Specialist Technical) September 2010 Examiners Report Term assurance The risk to the insured is that the benefit selected at inception turns out to be insufficient either due to changing circumstances or erosion from inflation. The policies tend to be inflexible, which means that the product cannot be altered to meet changing financial needs throughout the contract term. The policyholder is at risk of not being able to meet premiums due to accident, sickness and redundancy. For the convertible form, there is the risk of not being able to afford the new policy at conversion. Unit-Linked Endowment The maturity benefit will have some protection against erosion from inflation, however the policyholder is subject to risk from poor investment performance over the term of the contract and at the point the maturity benefits are payable. Poor investment performance can be due to either general market movements or poor investment management relative to other companies. The company may not have sufficient history of selling unit-linked policies so the historic unit fund performance may not be known, if the funds are managed internally. The minimum death benefit tends to be fixed in monetary terms and so could be at risk from erosion from inflation. The charges may be variable on the product and the policyholder may be at risk from unreasonable increases to the level of charges. There is a risk that the policyholder has to surrender the policy early on in its term and may as a result receive poor value for money due to high penalties or front end loaded charges. (iii) Risk to a company of selling the product Mortality The company is at risk from actual mortality experience being worse than that allowed for in the pricing of the contract. For the term assurance the premium cannot be changed to allow for this. The experience may differ due to model risk, parameter risk or random fluctuations risk. For term assurance sold to groups of lives, there is the risk from concentration and aggregation of risk from a large number of claims resulting from a single cause. Page 12

40 Subject ST2 (Life Insurance Specialist Technical) September 2010 Examiners Report The unit-linked endowment may enable the company to review the mortality charges applied on the product. However the company may be restricted in the frequency of the reviews or the level of increase that can be applied. Related to the mortality risk is an anti-selection risk, particularly for the individual term assurance product. There is less anti-selection risk for endowment assurances as these are more likely to have been purchased for savings rather than protection and are often linked with mortgages. Expenses and the effect of inflation There is a risk to the company of actual expenses being higher than those loaded into the term assurance or unit-linked endowment premium. There is also a risk that expense inflation is higher than assumed when the products were priced. In a similar way to mortality, the company may be able to review the charges applied on the unit-linked endowment, but may be restricted on the level of increases by policyholders expectations. Investment performance The company is at risk from adverse publicity or poor persistency if the investment performance on the company s unit-linked funds is worse than its competitors. The company is exposed to investment risk under the unit-linked endowment assurances to the extent that there are any guarantees regarding a minimum death or maturity benefit. In addition charges linked to the unit funds will also be reduced as a result of poor investment performance. There is some investment risk to the company under term assurances, but this is limited due to the low reserves and likely fixed interest investments. Withdrawals The company is at risk from withdrawal experience (lapses on the term assurance and surrenders on the endowment) being different than that allowed for in the pricing assumptions. Higher withdrawals than expected may have a selective effect on the mortality experience where healthy lives lapse their policy, worsening the mortality experience on those who remain. Higher withdrawals may also affect expense experience where fewer policies remain than expected reducing the company s ability to recoup overhead expenses. Higher lapses at the initial durations in force may impact the ability to recoup initial expenses that were incurred. Page 13

41 Subject ST2 (Life Insurance Specialist Technical) September 2010 Examiners Report Higher than expected withdrawals on the unit-linked endowment assurances also reduces expected future profit margins. Higher than expected withdrawals early in the policy term can be a significant problem under a decreasing term assurance product (where level premiums are used to support a decreasing benefit). New business There is a risk from selling too much new business that may affect the company s solvency position and administration capabilities. There is a risk from selling insufficient new business that may affect the company s ability to recoup expenses. The company is at risk from the nature and size of contracts being different to that allowed for in pricing the contract, invalidating any cross-subsidies allowed for, or increasing the mortality risk. A change in the mix of new business by source may invalidate the pricing assumptions used for mortality and expenses. Guarantees and options If convertible term assurances are being sold then there is a risk that the cost of the option loaded in to the premium is insufficient for the level of risk being taken on. There is also additional anti-selection risk associated with this option, given that there is no further underwriting. Competition There is a risk that the management may reduce premium rates on the term assurance in order to gain market share, particularly as the market is likely to be highly competitive. There is a risk that the actions of competitors reduce the market share for the company, impacting upon the company s ability to recoup expenses. Actions of distributors There is a risk that distributors may act in their own interests rather than in the interest of their clients. For example encouraging business to lapse and reenter on term assurances. There is a mis-selling risk due to poorly explained products resulting in unsuitable sales and the potential for damage to the company s reputation and regulatory fines. Counterparties It is likely that the company will utilise reinsurance to reduce its risk profile, in particular on the term assurance, this introduces the risk that the counterparty will default on its commitments. Page 14

42 Subject ST2 (Life Insurance Specialist Technical) September 2010 Examiners Report There will also be default risk on any corporate bonds held to back the term assurance business, although given the low reserves this may not be significant. Other There is a risk that there may be changes to the legal, regulatory or fiscal regime that will affect the policyholder and/or the company. The company is a risk from fraud perpetrated by staff, policyholders or third parties, for example, fraudulent claims on the term assurance. The company is also at risk from failure of systems and controls and from data errors. This question was generally well answered, parts (i) and (iii) more than part (ii). 6 (i) The aggregate asset shares at the year end are calculated from the following formula: Aggregate asset shares at start + premium income + investment income initial expenses renewal expenses commission claims shareholder transfers Working in $000: Total asset shares at start = 70,000 Investment income = 4,300 Premium income = 15,000*600/1,000+2,000*700/1,000 = 10,400 Initial Expenses = 1,500 Renewal expenses = 510 Renewal commission = 10,400*.02 = 208 Claims = (150*6,000+60*5,500+5*4,000)/1,000 = 1,250 Shareholder transfers on declared bonuses = 0.04*[(10, )*5,000+(5,000 60)*4,500+(2,000 5)*3,500)/1,000/9 = Shareholder transfers on TB on death = (150*1,000+60*1,000+5*500)/1,000/9 = 23.6 Total = 80,860, i.e. $80.86 million (ii) To determine the mortality factor to use: Expected deaths =.02*10, *5, *2000 = 264 Actual deaths = = 215 Factor F = 215/264 = (iii) Working in $000: To determine the investment rate to use for individual asset shares: (70,000+10,400 1, )*i = 4,300 i = 5.5% Page 15

43 Subject ST2 (Life Insurance Specialist Technical) September 2010 Examiners Report Now working in $: Renewal expenses per policy = 510,000/17,000 = 30 Initial expenses per policy = 1,500,000/2,000 = 750 Individual asset shares are calculated using the following: (Asset share at start + premium income + investment income initial expenses renewal expenses commission death rate * (death outgo + shareholder transfers on TB paid)/(1- death rate) shareholder transfers on declared bonus Note that shareholder transfers on declared bonuses are after death claims and so are not grossed up for deaths. Cohort A: Death rate =.02* ((5, *.98 30)*1.055 (6,000+1,000/9)* *.02)/( *.02).04*5,000/9 = 5,837 Cohort C: Death rate =.007* ((0+700* )*1.055 (4, /9)* *.007)/( *.007).04*3,500/9 = 139 For information (no marks) Cohort B: Death rate =.01* ((4, *.98 30)*1.055 (5,500+1,000/9)* *.01)/( *.01) -.04*4,500/9 = 4,782 (iv) The sum of the individual asset shares is (in $000): 5,837*9,850+4,782*4, *1,995 = 80,840 This differs very slightly from the aggregate asset shares due to the approximation in the death rates applied to the individual asset shares. Factors implied for each cohort : A: 150/10,000/.02 = 0.75 B: 60/5,000/.01 = 1.2 C: 5/2,000/.007 = 0.36 Page 16

44 Subject ST2 (Life Insurance Specialist Technical) September 2010 Examiners Report To apply separate factors to every mortality rate would be like deriving a company specific mortality table. This is likely to become volatile year on year and also impractical for systems. Using the individual asset shares (with F factor) means that mortality experience is smoothed. Using the F factor shares mortality risks between cohorts, which is consistent with the idea of pooling risks using the additions to benefits method. As aggregate asset shares and sum of individual asset shares are close then using individual asset shares to determine payouts will result in total payouts being close to the available asset share and hence little change in free assets. However, there will have been some cross-subsidy between cohorts. In addition the data could be spurious, with some rates being zero for cohorts in certain years. This could make asset shares for very similar cohorts different for no easily explainable reason. If the company wanted there to be no impact of mortality differences they could find the death factor by back solving to get the same answer, but this could be complex. A simple factor applied to all asset shares to eliminate the difference could be an alternative. This has the advantage of being simple to apply across all products and ensures that the difference between actual and expected deaths is spread across all business. In the above example the factor would be 80,860 / 80,840 = Care would have to be taken that any other differences between the sum of the individual asset shares and the aggregate assets were not mistakenly classed as mortality differences when adjustments are made. Part (i) was well answered although many candidates failed to write out the formula for the asset shares and hence their solutions were, in some cases, difficult to follow. Part (ii) was very well answered by those that attempted the question. Part (iii) was not well answered. Better candidates appreciated the need to use the factor F derived in part (ii) in the solution to part (iii). Part (iv) was very poorly answered, however those candidates that made reasonable attempts at parts(i) and (iii) were able to describe the differences between the two. END OF EXAMINERS REPORT Page 17

45 INSTITUTE AND FACULTY OF ACTUARIES EXAMINATION 18 April 2011 (pm) Subject ST2 Life 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 five 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 from the approved list. ST2 A2011 Institute and Faculty of Actuaries

46 1 (i) Describe the restrictions that may be applied to life insurance companies by governments or regulators. [6] (ii) Discuss how these restrictions might influence a life insurance company when designing a product. [6] [Total 12] 2 (i) Discuss how expenses can be a source of risk to a life insurance company. [3] A life insurance company has decided to reduce sales of one of its products substantially. Prior to this decision, this product accounted for 40% of the company s new business sales and approximately 30% of its in-force reserves. (ii) (iii) Discuss the measures that the company may take in order to reduce its expenses in these circumstances. [7] Explain why the company may need to review the expense assumptions used in pricing its products, as a result of the decision to reduce the sales of this product. [4] [Total 14] 3 A proprietary life insurance company currently prices its without profits immediate annuity business as follows: Premium = (annuity a x + expenses a x + cost of capital) 1.02 Where: annuity is the annual annuity payment. a x is the annuity factor for an annuity payable annually in advance for a life aged x using a best estimate mortality assumption and a discount rate equal to the expected earned rate. This earned rate is set equal to current yields on corporate bonds of appropriate term less a prudent allowance for credit risk. a x is the same as a x except that the discount rate is reduced to allow for expense inflation. expenses are best estimate per policy annual maintenance expenses. There are no initial expenses. cost of capital = 0.03 average term of the contract (initial reserves annuity a x expenses a x ) The 1.02 multiplier represents the margin for profit and risks. The local reserving basis requires the benefits and expenses to be discounted at a risk free rate of return, which is significantly lower than the rate used in pricing. ST2 A2011 2

47 The company has decided to launch a new profit-sharing immediate annuity product which is priced as follows: Premium = initial reserves 1.02 The contract will offer policyholders an initial starting annuity that is lower than that under the current contract, but with the potential for higher annuity payments if experience is favourable. The assets will be invested in the same corporate bonds as the existing annuity business. Each year, a calculation will be performed to assess the total surplus arising, and this surplus will be used to benefit policyholders. Annuity benefits can reduce from one year to the next, but cannot be less than the initial annuity. Any negative surplus is carried forward to offset future positive surpluses. The total surplus arising over year t will be calculated as: Reserves at time t 1 (or premium, if t = 1) + investment income annuity payments expenses reserves at time t. (i) (ii) Explain why it is appropriate for the company to use different bases for pricing and reserving. [2] Discuss the suitability of the various methods that are available to distribute the surpluses to the policyholders. [8] The marketing director believes that under this proposed new product policyholders should expect to receive higher annuity payments than under the existing product. (iii) Discuss this suggestion. [5] The marketing director has asked how the profitability of the two types of annuity product compare. (iv) Discuss how the various criteria for measuring profit could be used to answer the marketing director s question. [7] [Total 22] ST2 A PLEASE TURN OVER

48 4 For a number of years a life insurance company has sold a unit-linked endowment assurance product designed to provide a savings policy for a child, which is taken out by the parents on the child s birth. The maturity proceeds are paid to the child on reaching age 18. The marketing manager has suggested adding an option to new policies. The proposed option would be to convert the endowment policy, at maturity, into a level temporary annuity payable for five years from that date, or until the earlier death of the child. A guaranteed annuity conversion rate would be specified at the outset of the endowment policy. The aim would be to fund the child s university fees and provide support during the first few years of employment. The policy may not be surrendered once the annuity had started. The annuity would only be available to children who were going to university. The option would be charged for by increasing the annual management charge. (i) Outline the benefits to the policyholder of the addition of this option. [2] (ii) (iii) Outline the risks that remain with the policyholder, in relation to both the endowment and the annuity. [4] Discuss the risks to which the company would be exposed in respect of the proposed option. [4] (iv) Discuss how the company could minimise these risks. [4] (v) Describe the different methods that the company could use to price the option. [5] The marketing manager has suggested adding a further feature that would guarantee that all university fees would be met by the insurance company if the policyholder paid in more than a certain amount of total premium throughout the full term of the endowment. (vi) Discuss this suggestion. [5] [Total 24] ST2 A2011 4

49 5 (i) State the principles of investment. [2] A life insurance company has an in-force portfolio of level and index-linked without profits immediate annuities, conventional without profits term assurances and unitlinked contracts. The results of the previous valuation are summarised in the following balance sheet: Assets Liabilities Fixed Interest Immediate Annuities - Government Bonds 14,000 - Level 20,000 - Corporate Bonds 10,000 - Index-linked 5,000 - Index-linked Bonds 7,000 Term Assurances 5,000 Unit-linked Contracts Equities - Unit reserves 50,000 - Domestic 10,000 - Non-unit reserves 2,000 - Overseas 5,000 Solvency Requirement 5,000 Unit-linked Funds 45,000 Free Surplus 13,000 Cash 9,000 Total 100,000 Total 100,000 (ii) (iii) (iv) Describe an appropriate investment strategy for each of the items on the liability side of the balance sheet. [11] Discuss whether the assets held at the balance sheet date reflect an appropriate investment strategy. [7] Describe how a model may be used to determine an appropriate investment strategy. [8] [Total 28] END OF PAPER ST2 A2011 5

50 INSTITUTE AND FACULTY OF ACTUARIES EXAMINERS REPORT April 2011 examinations Subject ST2 Life Insurance Specialist Technical 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. T J Birse Chairman of the Board of Examiners July 2011 Institute and Faculty of Actuaries

51 Subject ST2 (Life Insurance Specialist Technical) Examiners Report, April (i) The restrictions that could be placed on a life insurance company are: A restriction on the types of contract that a life insurance company can offer; Restrictions on the premium rates, or charges that can be used for some types of contract; Requirements relating to the terms and conditions of the contracts offered, for example, with regard to how paid-up policy and surrender values are to be calculated; Restrictions on the channels through which life insurance may be sold or requirements as to the procedures to be followed or the information required to be given as part of the selling process; Restrictions on the ability to underwrite. For example, a prohibition on the use of the results of genetic testing, or to differentiate between different classes of policyholder e.g. males and females; and An indirect constraint on the amount of business that may be written. This may be through regulations regarding the minimum level of mathematical reserves that must be held, often combined with minimum requirements regarding the solvency margin of the company. The regulatory framework within a country may limit what a company would like to do in terms of investment. There may be restrictions on: The types of assets that a life insurance company can invest in. For example, localising assets in a specific currency; The amount of any particular type of asset that can be taken into account for the purpose of demonstrating solvency. For example counterparty limits to a particular issuer or limits on the type of asset; and The extent to which mismatching is allowed at all. The regulatory environment affects the liability valuation basis which can, for example, impact the choice of assets through their relationship with the investment assumptions used to value the liabilities. A particular asset distribution may allow a company to use a higher investment assumption and thereby reduce the value of liabilities. There may be regulatory restrictions in terms of which institutions can transact life insurance type business. Page 2

52 Subject ST2 (Life Insurance Specialist Technical) Examiners Report, April 2011 (ii) The aim of restrictions imposed by governments or regulators is usually stated to be the protection of the policyholder, and the company needs to bear this in mind when designing products. The restrictions may also have the effect of either restricting innovation or reducing the benefits that could otherwise be given to policyholders. Restrictions on the type of contract, the premium rates charged or on the terms and conditions offered will clearly have a direct impact on product design. Restricting the sales channels through which the products are sold will influence the complexity of the product sold. For example, a product sold through an IFA will be more complex than a product sold through direct marketing. Restrictions on the level of underwriting that can be used may influence the charging structure that can be used. A restriction on the level of underwriting may also result in products being offered with lower levels of death benefit. Restrictions may change the cross-subsidies between groups of policyholders which could impact the design of the product. If minimum levels of reserves are required, as a way of placing an indirect constraint on the amount of business that may be written, then this will influence companies into designing products that help reduce the level of reserves required. For example, companies may offer fewer guarantees if the reserving requirements are large or may offer unit-linked rather than nonprofit or with-profit contracts. Companies may also consider features which improve capital efficiency. If there are restrictions on the investments then this may influence the company to offer products with fewer investment guarantees such as guaranteed maturity values In addition a restriction on investments may create issues with unit linked funds that can be offered. The wider regulatory environment in terms of which institutions are allowed to transact life insurance type business is also important. In practice, life insurance companies are likely to have the monopoly of providing pure protection benefits, but not of providing savings benefits. The other institutions offering savings contracts, for example banks, will usually be subject to different regulatory controls from life insurance companies, leading to a non-level playing field with regard to the terms on which such contracts can be offered. Part (i) was generally well answered with better candidates giving the wide range of answers required. Part (ii) was poorly answered with many candidates not tailoring their answers to the question how the restrictions might influence the design. Instead they answered a wider question about how restrictions may influence a company generally and hence gained little credit. Page 3

53 Subject ST2 (Life Insurance Specialist Technical) Examiners Report, April (i) The overall risk is that the charges, either within premiums or explicitly defined in the product, accruing to the company are insufficient to meet the actual expenses incurred by the company. The risk is greater if the charges and expenses are not well matched in terms of timing and nature, and is reduced if the charges are variable. There is parameter and model risk with the assumptions. For example, the inflation assumption is set incorrectly when pricing. Expenses can be a secondary source of risk as a result of other business risks. For example expense assumptions may be invalidated by: Lower than expected investment returns, which will mean that charges linked to fund performance exacerbate the expense recovery problem; A change in the level of withdrawals or surrenders; or A change in the volume or mix of new business e.g. a fall in volumes will reduce the contribution to overheads and recovery of development costs. (ii) The company expects to reduce its sales by around 40%, if it substantially reduces the sales of this product. Hence the company will first consider how it can cut its sales expenses. The highest sales expenses are likely to be related to commission, which will clearly not be paid if the sales are not made. Reducing the commission level will help in the reducing volumes, but it would cut costs in respect of any distributors who will continue to sell the business at the lower commission levels. However the company is also likely to have other employee related expenses related to sales. The size of this will depend on the sales channels being used. For example, if the company employs a direct sales force, it is likely to consider reducing the size of this direct sales force through redundancy, especially if the direct sales force is paid a basic level of salary in addition to commission. The company will also reduce the number of sales managers and sales function, since a lower number will be required to supervise the sales force as it reduces. The number of sales branches, particularly in certain regions, and the number of support staff for the branches is likely to be reduced. In some countries, it may be relatively easy to reduce the number of employees with little cost to the company (e.g. in a country that has a high Page 4

54 Subject ST2 (Life Insurance Specialist Technical) Examiners Report, April 2011 turnover of staff the company can reduce employee numbers just via stopping recruitment). However, in other countries, making staff redundant is expensive and can in the short term increase costs rather than reduce them (this may especially be the case if employees generally have a long period of service with the life insurance company and this has to be reflected by law in their redundancy payment). Given such a significant expected fall in its sales, the company may also look to reduce the size of its sales infrastructure e.g. by closing branches or merging branches together to form larger branches etc. hence the company will reduce its rent and utility costs related to the branches. The company will also consider the head office costs associated with new sales for this product. For example, it should be possible to reduce the size of the new business processing department, that are responsible for setting up the new policies, and it may be possible to reduce the size of the department dealing with the ongoing administration of this product (depending on the extent to which this process is automated) or potentially underwriting department costs. The cuts in head office department staff expenses, may also lead to lower overall fixed expenses. For example, reductions in IT related costs and admin related costs such as office space. The company could consider outsourcing options for administration departments if this helps reduce costs. Marketing, advertising, and development costs are likely to be reduced. Lower volumes of in-force business will directly reduce investment related expenses. The company could attempt to invest more in the sales and marketing of other products to replace the lost business from this product in order to stop per policy costs rising. (iii) If the expense assumptions are not reviewed regularly then there is risk that the assumptions used are inappropriate and the company may make a loss or risk insolvency The expense analysis on which the current assumptions are based may have been carried out a number of years ago and hence the assumptions used will not have taken into account actual volumes written, mix of business or changes to the expense base. Notably expenses related to new business will now have to be split over a much lower number of new policy sales than previously. Page 5

55 Subject ST2 (Life Insurance Specialist Technical) Examiners Report, April 2011 Whilst new business expenses may fall (e.g. due to the closure or restructuring of some distribution channels), it may be that they do not fall immediately or they may not fall proportionately in line with the fall in new business volumes. Hence new business expenses for the remaining lines of business may increase as a result of the significant drop in sales of one product. In addition, overheads will now have to be split over a lower number of policies than may have been forecast in the past causing annual per policy maintenance expenses to increase. There may be other impacts that need to be built into the expense assumptions to be used in pricing e.g. a temporary increase in expenses due to high redundancy costs In addition the extent of any cross subsidies need to be reviewed across all products. The assumptions for existing business and potential new business for all products will need to be reviewed given the substantial shift in the relative volumes of business that is likely. Part (i) was reasonably well answered but many candidates failed to mention the matching of charges to expenses by nature and timing. In part (ii) whilst many candidates did cover the wider points such as outsourcing and impacts on administration departments they failed to focus on the direct impacts on the distribution channels and sales related expenses. Some candidates explained how an expense analysis should be performed, which wasn t required by the question. Only the better candidates considered the 2 nd order impacts on areas such as investment expenses. In part (iii) many candidates only referred to the impact on overheads. Better candidates included the impact on new business and the need to review cross-subsidies. 3 (i) The company has chosen to use pricing assumptions that broadly reflect expected future experience, with any risks to the company being allowed for mainly through the 2% loading and prudence in the credit risk assumptions. The company may prefer this approach to one that includes prudential margins in each assumption, since it may feel that it is easier to apply and more transparent. The company will not wish to include large margins in the pricing basis as needs to ensure the product is competitive. It would then not be appropriate for the same assumptions to be used also for reserving since there is no allowance for prudence in the mortality and expense pricing assumptions. This is not appropriate since a reserving basis needs to be prudent, as set out in the Groupe Consultatif valuation principles andlocal regulatory principles. In addition, the local requirements stipulate that the risk free rate of return needs to be used as a discount rate. There may be separate regulations regarding permitted pricing bases in this country. Page 6

56 Subject ST2 (Life Insurance Specialist Technical) Examiners Report, April 2011 (ii) The main possibilities are one (or a combination) of: cash bonus premium reduction benefit increase The premium reduction approach would not be possible since immediate annuities are single premium products. A cash bonus would be similar to a benefit increase if payable but would be a one-off bonus on the annuity in the current year. The cash bonus will vary from one year to the next which may create issues with policyholder expectations. A benefit increase will apply to all future annuity payments and hence the surplus recognition is spread over the lifetime of the contract. The amount can vary in future years Considering now how the additions to benefits may apply: Reversionary bonuses (RB) A regular reversionary bonus is a bonus that is declared on a regular basis, usually each year, throughout the lifetime of a contract. Once declared it becomes attached to the basic benefits Normally this cannot be taken away but this product is different, in that the amount can vary and the RB can be reduced. By declaring an RB the company are setting expectations for policyholders and hence the any reduction would create issues. Special reversionary bonuses This method is possible, but,. like the regular reversionary bonus, this would create expectations as it could imply that once declared it would be payable on top of every annuity payment. Terminal bonuses This method is not normally appropriate for annuities However, could make one-off payment to their estate on death, for example during a guarantee period Revalorisation method This method is commonly used in continental Europe. The profit, or surplus, to be given to a particular contract is expressed as a percentage r%, say, of that contract s supervisory reserve. The benefit under the contract and the premium payable by the policyholder are then Page 7

57 Subject ST2 (Life Insurance Specialist Technical) Examiners Report, April 2011 increased by the same amount. Clearly there is no future premium on this contract, but this method could work by simply increasing all future annuity payments by r%. Normally would increase reserves by investment profit, but the approach would need to be amended to include expense profit for this product, i.e. the r% would need to include expense surplus. Contribution method The Contribution method pays a dividend to the policyholder for the surplus that has emerged, which is determined using a standard formula. dividend = (V0 + P)(i i) + (q q )(S V1) + [E(1 + i) E (1 + i )] (Candidates were not expected to produce the formula to gain marks) The formula for determination of surplus in this case is similar to the approach for determining a dividend under the contribution method This method could be appropriate to use with adjustments. For example, it is possible for the formula to be adapted to take account of the impact of mortality on the remaining benefits, and for the formula to be rearranged to fit the circumstances. General points Normally, from the point of view of the insurer, the probability of remaining solvent is increased by reducing and delaying the distribution of any available profits. The company may wish to consider an approach which enables them to smooth the release of surpluses/losses over time. The approach used may depend on the country/territory of the business, and on the methodology/approach used for other products sold by the company. (iii) The existing product provides an annuity which is fixed and cannot increase. The new annuity provides a lower starting point which can potentially increase to provide a larger annuity than the existing product. This means that policyholders with a shorter expected lifespan may benefit from the existing product. The new product guarantees a lower annuity and so the reserves are lower which will reduce the cost of the capital. This would increase the amount of surplus available on the new contract. The lower guarantee also increases the risk to the policyholder. Page 8

58 Subject ST2 (Life Insurance Specialist Technical) Examiners Report, April 2011 The new product is likely to have higher administration expenses, which may reduce the annuity value. There is prudence in the pricing basis for the corporate bond default risk for the existing product. Assuming the defaults reflect the best estimate, then the new annuities will benefit from not having this prudence built into the premium basis. On the other hand, if defaults are worse than expected this will mean the new annuity will be lower than that for the existing product in respect of this assumption. The old basis allows for a liquidity premium in the earned rate which gives a higher initial annuity; the new basis does not. If this liquidity premium is not achieved (e.g. the company is forced to sell prior to maturity) then the new basis would give a lower level of annuity in respect of this. The new annuity will be priced on prudent mortality and expense assumptions, So we would expect surpluses to arise equivalent to these prudential margins if mortality and expenses are as expected. Hence the new and old products would be on an equivalent basis. If mortality or expenses are better than expected, the new product would benefit whereas the old one does not. If mortality or expenses are worse than expected, then the new product gives a lower annuity benefit in respect of these assumptions. However, the new annuity cannot go below the initial annuity and so experience being worse than the reserving basis would only impact the annuity if these losses are offset by surpluses in other assumptions. (iv) Profit criteria: The company could use the following different methods for comparing profits: net present value, expressed in different ways internal rate of return discounted payback period The net present value is the present value of the cashflows discounted at the risk discount rate. The net present value of the new annuity is simply 2% of the premium since all future expected surpluses go to enhance payouts. On the net present value approach, the old product is likely to produce a higher value for the same given premium, but this depends on the discount rate assumed. Page 9

59 Subject ST2 (Life Insurance Specialist Technical) Examiners Report, April 2011 This is because on a best estimate basis the prudence in the default assumptions used in pricing will fall into profits. In addition, the reduction in the annuity for any cost of capital will also fall into surplus. Given a choice between the future cashflows from two different investments, economic theory states that an investor should choose the one with the higher net present value. However, this assumes that when two risky investments are compared each is discounted at a risk discount rate appropriate to its riskiness. The riskiness of the new annuity cannot be measured by using a risk discount rate since future cash-flows on a best estimate basis are zero. The internal rate of return is defined as the rate of return at which the discounted value of the cashflows is zero. All other things being equal, a company should prefer a contract that has a higher internal rate of return. However, the IRR for the new annuity is meaningless as under these projections there would be a positive cash-flow at outset and zero thereafter. For the comparison to work it would need a negative cash-flow at outset and positives thereafter. The discounted payback period is the policy duration at which the profits that have emerged so far have a present value of zero, i.e. it is the time it takes for the company to recover its initial investment with interest at the risk discount rate, or the period it takes to pay back the initial outlay allowing for interest. In general the company will prefer a contract with a short discounted payback period The discounted payback period will not usually agree with the net present value as it ignores completely all the cashflows after the discounted payback period, and in this case the new product will have a discounted payback period of zero (i.e. the initial investment is recovered at outset). The company therefore has to consider the fact that the NPV may be higher for the existing product, but it has more risk attached as the guarantees are higher. The existing product also has a longer discounted payback period. The company will consider the capital position of the company and the appetite for risk before deciding which criterion is more suited. This question was generally poorly answered, with many candidates failing to tailor their answers to the question asked. Part (ii) was very poorly answered with many candidates not considering forms of distribution other than benefit increase (e.g. cash bonus and premium Page 10

60 Subject ST2 (Life Insurance Specialist Technical) Examiners Report, April 2011 reduction). Many candidates did not tailor their answer to the question and instead just listed generic bookwork and gained little credit. The better candidates considered whether an approach was suitable for the product (e.g. terminal bonus not relevant). Part (iv) was largely bookwork and was well answered by those who made it this far through the question. However many candidates failed to show an application of the bookwork to compare the two products under discussion. 4 (i) The product is valuable if the option is in the money when the policy matures i.e. when interest rates are low, and provides a guaranteed income for the child once they reach 18 and if they go to university. The income matches a potential future liability outgo and enables parents to plan potential future cash-flows. There is less risk of the child spending the proceeds all at once on items the parents might deem as wasteful. It may encourage the child to go to university, in line with possible government initiatives to encourage further education (ii) The policyholder retains the investment risk during the first 18 years of the policy and the risk that returns are lower than expected. Risk of insolvency of the insurer. Risk of changes in tax legislation that reduce the value of the policy. If charges are variable during the unit-linked investment phase, risk of higher than expected charges. Risk of low surrender payments before the option is taken, particularly early in the period compared with premiums paid. The parents circumstances may change and result in problems paying premiums, resulting in them wanting to make the contract paid-up. Risk that the option is out of the money when the policy matures and hence the option fee might not be felt to have been good value. Risk that the student may not go to university, or may go later rather than at age 18 which would invalidate the option.. If the option is taken: Risk that return offered by the annuity is less than returns available if invested the money direct. Risk of university fees being higher than expected, eg due to high inflation, which would erode the value of the level annuity. Page 11

61 Subject ST2 (Life Insurance Specialist Technical) Examiners Report, April 2011 Risk that the student dies whilst the annuity is in payment, so the parents would not feel that this was good value. Risk that the student s situation changes and they would have needed the whole fund for a large lump sum purchase e.g. deposit for a house (iii) Short term investment yields at maturity are less than assumed in pricing the annuity conversion rates so the option bites and the company hasn t received enough income from the charges to meet the cost of the option This risk would be exacerbated if investment returns have been high over the first 18 years so that the unit-linked fund on which the conversion rates are to be applied is higher than expected. However the charges to meet the cost of the option are linked to fund values, so these would be higher than expected which offsets the above risk to some extent. The company is not able to purchase assets (e.g. 5 year bonds) which match the potential future liability appropriately. Take up of the option is greater than expected when in the money This is exacerbated if option terms are not strict enough, e.g. don t require evidence of offer from university Definition of university isn t strict enough and more institutions than expected are classed as universities in the future. Reputational risk e.g. if do not pay out when policyholders expect or policies mis-sold at point of sale. Marketing risk from policyholders who are not entitled to the annuity and so may be aggrieved by having to pay for others, or want the option themselves. Expenses risk over the whole period from birth, since the conversion rates would have allowed for an expected level of expenses which might prove to be much higher than expected, particularly if inflation has been high Counterparty risk if used short term corporate bonds to back the annuity once in payment or if derivatives such as swaptions are used to back the liabilities. Volumes sold are different to those expected. Low volumes may lead to expenses not being recouped and high volumes may lead to issues with customer services. The mortality risk is minimal and hence the company does not have a significant exposure to this risk. Page 12

62 Subject ST2 (Life Insurance Specialist Technical) Examiners Report, April 2011 (iv) Include sufficient margins for prudence within the pricing of the option Hedge the option with appropriate assets. For example, purchase a swaption which will enable the company to swap floating rate returns for fixed returns at the rate guaranteed if yields move into the money Monitor experience and re-price the option for new business regularly Reputational risk could be managed through clear initial marketing and sales literature, which may be via an appropriate sales channel. In particular need to ensure the terms and conditions for take-up are clearly defined and limited. For example, only allowing option take up on certain universities, only allow option take-up if met certain conditions. Charge a fixed fee rather than an increase to the annual management charge to reduce the risk of the income from the fee not being sufficient Make the option charge variable to allow the company to react to unfavourable experience When the annuity is in payment, invest in government bonds to reduce credit and counterparty risk Monitor actual expenses regularly and put processes in place to control the level of expenses incurred. Perform adequate research on the potential market before launch in order to determine a realistic estimate of expected sales volumes. The company could consider reinsuring the option, provided there were reinsurers available to accept the risk at a cost that is reasonable. (v) (a) Option Pricing techniques A guaranteed annuity rate is analogous to either a call option on bonds with an exercise price that generates the required rate of return or a swaption which gives the holder the option to swap floating rate returns at the option date for fixed rate returns sufficient to meet the guaranteed annuity option. The option can be valued based on the market price of the similar derivative, if such a price is readily available. (b) Stochastic simulation Another approach is that the company would price the option by building a stochastic model. Page 13

63 Subject ST2 (Life Insurance Specialist Technical) Examiners Report, April 2011 The model would project future investment returns, particularly shortterm bond yields, stochastically together with assumptions about the take-up rate of the option which would take account of expected policyholder behaviour and whether the guarantee is in the money at maturity The price of the option would be determined by considering the average present value of a number of simulations. The charge used to recover the price of the option would also need to be included in the stochastic projection, particularly since it is to be expressed as a percentage of the fund. A margin is likely to be added to the cost of the option. (c) Alternatively the company may use a closed-form solution (e.g. Black Scholes) to value the option. (vi) This option is likely to be popular with policyholders who like the certainty of knowing that paying a regular premium would guarantee university fees being met. It may therefore increase sales of the product and hence increase profits to the company. However, the company should consider whether the option would in fact give enough additional sales to offset the development costs and risks arising The additional premium required for the guarantee may result in the product being too expensive and demand very low. However, accumulating premiums may encourage continued payment which can improve persistency experience. There is a large risk that the fees would increase by more than the life insurance company expects. and the shareholders would have to meet any shortfall if the pricing of the option was insufficient. This exposes the company to even more investment risk over the first 18 years of the policy since the value of the policy at maturity will be key. The company could mitigate this risk by restricting the fund choice available to policyholders. However, investment in lower risk (fixed interest) funds can cause problems with the annuity rate conversion option, since their value will be higher when the option bites and so the additional cost to the company is even higher since the conversion rate is applied to a higher fund. The company could pre-negotiate fee deals with certain universities. Page 14

64 Subject ST2 (Life Insurance Specialist Technical) Examiners Report, April 2011 The proposed feature also introduces additional administration burden, e.g. are the payments made to the university or to the student; if the former than this increases the number of transactions needed; if the latter then would need to check the amounts carefully to avoid fraud. Further cost from needing to include in the systems a calculation that accumulates the amounts paid in order to check whether the total has been triggered. The total may be seen as being arbitrary; potential reputational problems if fees are denied to someone who fell a little short e.g. due to missed premiums during economic recession. The terms and conditions should be clearly defined. For example stating clearly what university fees cover, how long paid for etc There is a risk of anti-selection from people whose children are attending universities with high fees. For example, payment of late top ups in order to get the guarantee. The company would need to consider whether competitors offer similar products and if so what their terms are. This question was relatively well answered. Where candidates failed to understand the design of the product and hence did not make sensible comments e.g. by indicating that the investment risk during the first 18 years of the original product, was with the company not the policyholder. In part (v) many candidates focused on the European and North American style approach to put options rather than considering the approach for pricing the product. Part (vi) was answered reasonably well with better candidates gaining points for thinking about the wider aspects. 5 (i) Investment should maximise the overall return on the assets. In order to minimise risk, the company should select investments that are appropriate to the nature, term and currency of the liabilities. The company may depart from the above depending on the level of free assets. Or The company should invest so as to maximise the overall return on the assets, subject to the risk being taken on being within the financial resources available to it. Candidates were given credit for either solution. Page 15

65 Subject ST2 (Life Insurance Specialist Technical) Examiners Report, April 2011 (ii) Taking each of the liabilities in turn Level annuities: The liability is guaranteed in money terms and can be very long term. There is a requirement for a regular income from assets to pay the annuity outgo Fixed interest securities are likely to be the best match with a mix of government bonds and corporate bonds. Corporate bonds give higher yields (but with higher default risk), which may be important if annuity pricing is competitive or if government bonds are in short supply. The company should aim to match cashflows by term however this may be difficult as there may not be bonds available of sufficiently long term. Index-linked annuities: The liability is guaranteed in terms of prices index, will be long term, and will require a real return from assets to pay annuity outgo. Ideally the assets would be linked to the same index as the liability. Likely to match by index-linked securities if available, otherwise a basket of fixed interest assets and/or equities/property. Term assurance liability is guaranteed in money terms, and is likely to be matched by cash and fixed interest of appropriate term Expenses - for all the above products expenses may be matched by indexlinked bonds. Unit-linked: The unit liabilities should be matched by unit-linked funds directly. Non-unit liabilities are held in respect of expenses & mortality risk. In practice it will be difficult to match exactly, but could be matched by fixed interest/cash/index linked or real assets. Solvency Requirement is likely to match with low risk investments e.g. cash and/or fixed interest securities. Free Assets can be invested in real assets, e.g. equities, but extent will depend on level of mismatching elsewhere and will want to maximise overall return Page 16

66 Subject ST2 (Life Insurance Specialist Technical) Examiners Report, April 2011 General points: should also aim to hold assets in the same currency as the underlying liabilities, need cash for liquidity purposes. (iii) Asset mix there is a high level of mismatch (of 5,000, 10% of liabilities) on unitlinked liabilities the higher the mismatch, the higher the risk of losses to the company so it may need to be reduced particularly if free assets fall total fixed interest is more than enough to cover guaranteed liabilities so also would appear that this could be matching some of the linked funds index-linked bonds of 7,000 held to match indexed annuities and non-unit reserves and likely some of term/level annuity liabilities relating to expenses. Level of index-linked bonds perhaps looks low compared to liabilities, but there may not be sufficient index-linked bonds in market. Mix of corporate and government bonds may be satisfactory, although credit risk on corporate bonds may mean the default risk is too high, depending on the credit ratings of these bonds. Equities with total holdings of 15,000, appear to be matching the free surplus and some of the unit-linked liabilities. There is a relatively high level of overseas equities. Difficult to say if this is appropriate, but need to assess currency of mismatched linked liabilities General comments There is a reasonable free surplus which gives the company an opportunity to mis-match to some extent to seek higher potential returns. This may, for example, be the reason why the company has invested in overseas equities. There is a high proportion of cash which can be good for liquidity. However too much cash can limit potential for high investment returns. Credit was given for any sensible numerical examples and comments which indicated that a candidate had analysed both the assets and liabilities of the company. Page 17

67 Subject ST2 (Life Insurance Specialist Technical) Examiners Report, April 2011 (iv) Use model of in-force business, using model points and a model investment portfolio based on company s proposed (or current) investment strategy Liabilities and assets are projected forward using expected future experience for assumptions, and test variations on these best estimate assumptions. For liabilities use current basis and project forward to end of each year on supervisory basis Need to make assumptions dynamic and linked to assumptions used to project assets Project all assets forward using assumptions for future investment return For assets a stochastic investment model can be incorporated to project future investment income and capital gains/losses, and could also use stochastic inflation rate models to project future expenses Look at statutory solvency position at end of each year including a projection of solvency requirement. Will need to identify what comfortable level of solvency is, which will depend on regulatory requirements, nature of business and the level of cover over solvency margin provided by competitors. May also take into account future new business growth plans and hence future new business strain Results will give a statistical distribution of amounts available to meet solvency requirement, and hence calculate probability of future insolvency (probability of ruin). This should be compared to the expected level chosen at outset. Repeat the process for different investment strategies. May want to extend process such that it includes the effect of investment strategy on future shareholder earnings would want to develop investment strategy that maximises future shareholder income whilst minimising probability of insolvency. This was a relatively straightforward question, and the content has been examined many times before. In general the question was well answered. The poorer answers did not provide enough detail in part (ii), and a number of candidates surprisingly suggested that the solvency requirement would be matched by equities. Some candidates referred to withprofits, which was not required by the question. In part (iii) a number of candidates showed a lack of understanding of how unit linked contracts work, suggesting that the difference was due to actuarial funding. Candidates who made sensible comments or provided a different analysis to that shown in the solution to part (iii) were given credit. Part (iv) was generally well answered. END OF EXAMINERS REPORT Page 18

68 INSTITUTE AND FACULTY OF ACTUARIES EXAMINATION 26 September 2011 (pm) Subject ST2 Life 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 six 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 from the approved list. ST2 S2011 Institute and Faculty of Actuaries

69 1 A well-established life insurance company is looking to improve its capital position by putting in place some financial reinsurance. (i) Describe the two main types of financial reinsurance. [4] (ii) Explain how these can improve the capital position of the company. [6] [Total 10] 2 The Finance Director of a life insurance company has suggested that in order to cut costs, the amount of underwriting that the company carries out should be reduced. Discuss this suggestion. [11] 3 A proprietary life insurance company sells conventional with profits endowment assurances. (i) Describe the risks to the company of selling this type of business. [7] (ii) Describe the risks to the policyholder of purchasing one of these contracts. [4] (iii) Describe the method usually used to calculate the asset share for this type of contract. [8] [Total 19] ST2 S2011 2

70 4 A proprietary life insurance company sells only three-year term single premium unitlinked endowment assurances. The company provides financial returns annually to its regulator. At year end 2010, these showed: Assets 5,000 Unit reserves 4,000 Non-unit reserves 300 Solvency capital requirements 200 Of the unit reserves in force, 25% mature on average six months after the valuation date, 25% mature in 1½ years, and 50% in 2½ years. Non-unit reserves, which are calculated on a very prudent basis, and solvency capital requirements are released in the same pattern as the unit reserves mature. In its embedded value as at year end 2010, the company assumes the following: Earned investment returns on all assets of 10% per annum. Annual management charges of 2% of unit funds, deducted half way through the calendar year. Expenses of 1% of unit funds, incurred half way through the calendar year (you may assume that charges and expenses occur before any policies mature). Lapses and mortality are so low that for embedded value purposes they can be ignored. Risk discount rate of 12% per annum. No tax is payable. (i) Calculate the embedded value of the company. [8] (ii) (iii) Describe how the approach to determining the embedded value would be different if the contracts were all conventional with profits contracts with reserves based on a net premium valuation, and shareholder transfers based on a percentage of policyholder reversionary and terminal bonus declarations. [No calculations are required.] [6] Describe the impact of increasing the level of prudence in the reserves on the embedded value of both unit-linked and conventional with profits contracts. [3] [Total 17] ST2 S PLEASE TURN OVER

71 5 A life insurance company has been selling a unit-linked whole life assurance product for a number of years. The unit-linked whole life product allows the policyholder to pay a monthly premium for a selected premium payment term of between five and twenty-five years. The policyholder can choose from a variety of available unit-linked funds and can switch between funds at any time, subject to a switch charge. Each fund is subject to an annual management charge that varies by fund. Units purchased in the first two years are initial units; thereafter, accumulation units are purchased. The only difference between these types of units is that the initial units have a higher annual management charge than the accumulation units. On death the policyholder will receive 101% of the bid value of the initial and accumulation units held at the time of death. On surrender after the first year, a surrender penalty is applied to the bid value of units equal to the value of the outstanding annual management charges on the initial units from the point of surrender to the 70th birthday of the policyholder. If premiums are stopped during the first year, the policy terminates with no value. Policies may be made paid-up, or premiums may be reduced or increased, after the first year. (i) List the assumptions that would be required when setting up supervisory reserves for this product. [3] Recently, the company has experienced poor persistency on this product, both in terms of full surrenders and contracts reducing or stopping paying premiums. It is about to conduct its annual investigation into the persistency experience over the past year on this product. (ii) Describe how this investigation would be performed. [10] (iii) Suggest possible reasons for the poor persistency. [6] [Total 19] ST2 S2011 4

72 6 A life insurance company has been writing conventional without profits whole life policies for the last ten years. (i) (ii) List the principles that the company should follow when calculating surrender values. [4] Outline the retrospective and prospective methods of calculation of surrender values. [4] When the product was launched a table of surrender values by policy duration was created which was a blend of values calculated under these two methods. The prospective values were created using a realistic basis at the time of launch and have not been reviewed since. The surrender values are not guaranteed and the table has not been disclosed to policyholders. (iii) Discuss why the company used a blend of approaches. [5] The company has seen less profit emerging per surrender than was anticipated when the product was launched. (iv) Discuss what may have led to this lower than expected profit per surrender. [8] (v) Suggest ways in which the surrender value terms could be changed in order to increase the profit made on surrender. [3] [Total 24] END OF PAPER ST2 S2011 5

73 INSTITUTE AND FACULTY OF ACTUARIES EXAMINERS REPORT September 2011 examinations Subject ST2 Life Insurance Specialist Technical Purpose of Examiners Reports The Examiners Report is written by the Principal Examiner with the aim of helping candidates, both those who are sitting the examination for the first time and who are using past papers as a revision aid, and also those who have previously failed the subject. The Examiners are charged by Council with examining the published syllabus. Although Examiners have access to the Core Reading, which is designed to interpret the syllabus, the Examiners are not required to examine the content of Core Reading. Notwithstanding that, the questions set, and the following comments, will generally be based on Core Reading. For numerical questions the Examiners preferred approach to the solution is reproduced in this report. Other valid approaches are always given appropriate credit; where there is a commonly used alternative approach, this is also noted in the report. For essay-style questions, and particularly the open-ended questions in the later subjects, this report contains all the points for which the Examiners awarded marks. This is much more than a model solution it would be impossible to write down all the points in the report in the time allowed for the question. T J Birse Chairman of the Board of Examiners December 2011 Institute and Faculty of Actuaries

74 Subject ST2 (Life Insurance Specialist Technical) Examiners Report, September 2011 General comments on Subject ST2 The Examiners Report covers more points than would be expected to get full marks. This is so that alternative approaches to questions by different candidates can be accommodated within the marking scheme. Candidates are expected to show knowledge of the relevant content of the Core Reading, but those who tailor their answer to the specifics mentioned in the question will score more highly than those who answer in a more generic way. Comments on the September 2011 paper As usual, questions that focussed on knowledge of the Core Reading were well answered. The numerical question, 4 (i), was, however, poorly answered. Whilst the report below gives quite a detailed solution, many candidates were unable to cover the basic calculation of the value in force. Similarly, answers to questions that required candidates to think more widely, such as 6 (iv) did not show a comprehensive enough of answer. Candidates should use Examiners Reports to practice applying their knowledge to the situations set. Page 2

75 Subject ST2 (Life Insurance Specialist Technical) Examiners Report, September (i) Asset enhancing The value of in-force (VIF) is the excess of the statutory reserves over the realistic reserves plus the priced margin in a portfolio that will be released over time. The reinsurer gives the insurer funds now that are repaid over the next few years from the future emergence of the VIF as cash, i.e. as and when future profits arise on a particular block of business they are used to pay off the loan that was provided by the reinsurer. This is usually a contingent loan arrangement, since the repayment of the loan is dependent on the future profits arising and the block of business on which the loan has been secured will be specified. Liability reduction This is known by a number of alternative names, including virtual capital and time-deferred-stop-loss. Under this arrangement the reinsurer agrees to cover Xm of claims relating to policies of the longest term within a block of reinsured business. As the VIF emerges, the insurer recaptures the risks over time. The Xm of claims covered is usually chosen to be a small percentage of the expected VIF. The reinsurer charges a fee for this service. (ii) Asset enhancing financial reinsurance allows the insurer to increase its assets by changing its VIF (which is usually an unrecognised asset in terms of the regulatory balance sheet of the insurer) into cash. The cash received from the reinsurer is recognised as an increase in assets of the insurer. There is no change in the liabilities of the insurer, since if the VIF is not recognised as an asset on the balance sheet of the insurer because of its contingent nature then anything contingent on it does not have to be recognised as a debt. Hence from a regulatory perspective, the assets are increased, the liabilities are unchanged and hence the regulatory capital position of the insurer is improved. Note that this only assists in improving the regulatory balance sheet position where there is value in the VIF (i.e. regulatory accounts are based on statutory reserves that have implicit margins, rather than a realistic balance sheet approach e.g. such as that envisaged in the EU under Solvency II). Under liability reduction financial reinsurance, as the name suggests, the insurers statutory liabilities are reduced due to the passing of Xm of claims liabilities to the reinsurer. There are no changes on the assets side of the balance sheet, aside from the small impact of paying the (small) fee to the reinsurer. There is no need to recognise the payment of the full reinsurance premium (for the Xm claims) in the balance sheet, because this is effectively made contingent upon the emergence of future surpluses and the reinsurance is expected to be recaptured so that it does not have to be paid. Hence there is a reduction in the liabilities, very little change in the assets, resulting in an improved regulatory capital position for the insurer. Page 3

76 Subject ST2 (Life Insurance Specialist Technical) Examiners Report, September 2011 Note that there may also be additional benefits, from a capital perspective, to the insurer of putting such a financial reinsurance arrangement in place. For example, if the company operates in a regulatory regime that requires a solvency margin, this may be reduced. The passing to the reinsurer of Xm of the longest claims may result in the insurer s assets and liabilities being more closely matched. e.g. in the case of an immediate annuity portfolio where the longest dated expected annuity payments are reinsured, it may be very difficult to purchase assets of sufficient duration to match the liabilities hence by reinsuring the longest claims, it may be possible to improve the matching of the assets and liabilities, which may have a secondary impact of reducing the amount of mismatch reserve that has to be held in the statutory accounts, reducing the statutory liabilities further and improving the capital position further. This was a bookwork question, with part (i) generally being answered better than part (ii). When answering part (ii), candidates tended to provide the basic information in the solution, but failed to consider the potential additional benefits of the liability reducing financial reinsurance. Another feature of candidates solutions was that they answered both parts (i) and (ii) in the initial part of the question and then struggled to answer the subsequent part. Candidates were not penalised for this when being marked. 2 The Finance Director is correct that reducing underwriting can reduce expenses (e.g. reduced number of underwriters, fewer medical examinations).these need to be considered against the implementation costs of any new processes. It can also result in increased volumes of business sold. This is because distributors and policyholders may favour a more relaxed underwriting stance, with less hassle factor and reduced processing time. However, the company needs to weigh these benefits up against greater costs in other areas. In particular it needs to consider higher potential claims costs and the risk of increased anti-selection. If the company, therefore, takes a very prudent approach given the limited information, then more customers may be declined than previously and this could adversely impact the company s reputation. Reducing claims underwriting is likely to lead to increased fraudulent claims being paid. Reduced financial underwriting may lead to moral hazard e.g. cases of policyholders deliberately over-insuring knowing that they will shortly die and a claim will arise. Firstly the company will want to consider the type of products written, since underwriting is more important and onerous for some types of product (protection business) than others (products principally used for savings). The company might want to consider those cases that are fully underwritten but where no additional premium is ultimately charged, to determine whether there are ways to reduce the number of cases that unnecessarily go through the full underwriting process. This type of analysis should also compare the costs involved in obtaining further evidence at lower sums assured versus the additional premium charged/ the savings in respect of cases refused. Page 4

77 Subject ST2 (Life Insurance Specialist Technical) Examiners Report, September 2011 The company may want to consider other ways to manage its mortality risk, e.g. reducing the maximum sum assured that is available on term assurance, or carrying out less expensive on-line automated underwriting checks (e.g. that may result in more refusals for cover than would have been the case in the past, for example if only those that answer all of the health questions positively are offered cover). The Finance Director may be able to make expense savings in the underwriting department in other ways, e.g. reviewing the number of cases handled by each member of underwriting staff, the ratio of full underwriters to support staff. For example, if it is found that the underwriting of one particular product absorbs most of the underwriting resource, the insurer may want to consider whether to stop selling this particular product, or may consider introducing a modified product that requires less underwriting. The insurer will need to consider the level of underwriting carried out by its competitors for this product, to ascertain whether it is generally in line with the market or is taking an overly cautious approach. A reinsurer may be able to offer advice on this. If reducing the level of underwriting would put the insurer out of line with its competitors then the insurer is likely to experience the sentinel effect and attract a disproportionate share of the anti-selection risks. The insurer will want to charge for this additional risk in this instance and is likely to have to increase premium rates to compensate for the additional anti-selection risk. This can exacerbate the anti-selection effect, as the healthier lives are more likely to be take advantage of lower basic premium rates offered elsewhere where there is stricter underwriting. The company may be able to reduce its premium rates due to the expected lower underwriting costs, but this is unlikely as it seems that the Finance Director is looking to reduce costs and increase profit margins rather than passing on all the cost reductions through to policyholders via lower premium rates. Further, if reinsurance is used then it is likely that the reinsurer will either increase its rates significantly if the level of underwriting is significantly reduced, or in the extreme may not wish to continue reinsuring this product, and this might also be reflected in higher premiums (or lower profit margin). Also, less underwriting will mean less homogeneity, making pricing harder. If premium rates are increased then this is likely to be unpopular with the insurer s sales channels, which could offset the sales advantage from the reduction in the level of underwriting. There are other implications of lower sales e.g. increased per policy overhead costs, lower market share etc, and these may not be implications that the Finance Director has intended. The company may also need to hold higher reserves, due to increased uncertainty about future mortality experience. Need to consider any regulatory restrictions, although as this is a proposal to reduce underwriting, then this is not likely to be an issue. Candidates tended to provide superficial answers that did not cover as much of the variety of points as would have been expected. The question was asking the candidate to apply the core reading to a specific scenario but many candidates failed to be able to master this technique. Page 5

78 Subject ST2 (Life Insurance Specialist Technical) Examiners Report, September (i) The nature and extent of any financial risks for the company from investment, expenses, and demographic assumptions are materially reduced as a result of the experience being shared between the company and the policyholder via bonuses. However, they can have some impact on profits where shareholder transfers are related to the declaration of bonus. The level of guarantee provided under such a contract increases the risk from experience being worse than expected. In particular, there is a risk that investment returns are poor resulting in the asset share falling below the minimum guaranteed benefit (sum assured plus attaching declared bonus). At times when the asset share is negative (e.g. early in the term), there is a financial risk from withdrawal. At other times, whether there is such a risk depends on how any withdrawal benefit paid compares with the asset share. The level of risk also depends on the degree to which surrender profits/losses are passed back to customers via the asset share. Expenses being higher than expected and mortality higher than expected (if there is a guaranteed death benefit in excess of asset share) are other risks that are shared with the policyholder. There is also a marketing and reputational risk under these policies: policyholders may not understand the maturity benefit that they will receive, and in particular they may expect the maturity benefit to be large enough to e.g. pay off a loan amount, which may not be the case if investment performance during the contract term was poor and the bonuses added lower than expected. This risk will be compounded if policyholders are provided with projections of maturity benefits at outset, under different investment performance scenarios, if the actual investment performance is worse than anticipated in those scenarios. There is a risk to the insurer from selling insufficient business volumes resulting in the company being unable to cover fixed costs. Although the company can charge such costs to asset shares, there may be regulatory or marketing constraints to the extent that this can be done. Low new business volume risk is related to the risk of competitors taking actions that increase the relative attractiveness of their products, e.g. increasing bonus rates. There is a risk to the insurer from selling too much business leading to excessive new business strain and which may impact the company s ability to administer the policies. The insurer may be at risk from the mix and size of the policies sold being different to that allowed for when pricing the product, although this will depend on the extent of cross-subsidies acceptable within the bonus allocations. There may be a risk of inappropriate management actions, such as declaring unsustainable bonus rates in order to obtain a short-term marketing advantage. Overall, smoothing and PRE may limit the company s ability to mitigate the risks by limiting its ability to payout asset share and/or to charge significant adverse experience to asset shares. Page 6

79 Subject ST2 (Life Insurance Specialist Technical) Examiners Report, September 2011 (ii) The main risk borne by the policyholder is that the amount of benefit provided eventually turns out to be insufficient or lower than expected, both on death and on maturity. With profits contracts can provide some protection against the ultimate benefits being eroded by inflation, to the extent that the policyholder does not also choose to reduce the guaranteed level of benefit in anticipation of the future value of surpluses which they might enjoy. Where the death benefit is a fixed amount, then there is the possibility of erosion by inflation. The policyholder is exposed to the risks that final bonuses are lower than expected due for example to: investment returns being lower than expected expenses being higher than expected other surpluses being lower than expected (e.g. higher than expected guaranteed mortality payments) The smoothing of benefits mitigates these risks to some extent. The policyholder carries some risk of insurer becoming insolvent. However this should be less than if the company just sold conventional without profits contracts, as future surpluses may be used to maintain solvency, before being distributed to policyholders. The policyholder is exposed to the risk of being unable to maintain premiums due to accident, sickness, redundancy, or other loss of income and the benefit received if the policy is surrendered or made paid-up may not appear to be good value for money, particularly early in the policy term. There is the risk that the policyholder does not understand the policy; therefore it may not meet their needs. For example, if the policy was taken out to repay a mortgage on a house and the risks not explained. There is a risk that changes in taxation may alter the value from the policy. (iii) The asset share is the accumulation of premiums less deductions associated with the contract, accumulated at the actual rate of return earned on investments. An allocation of profits on any without profits business written in the with profits fund will also be allocated to the asset share. Deductions include all expenditure associated with the contract, in particular: commission paid direct expenses incurred the cost of providing any minimum guaranteed life cover possibly on a smoothed, rather than current cost, basis the cost of providing any options, e.g. option to increase minimum guaranteed life cover Page 7

80 Subject ST2 (Life Insurance Specialist Technical) Examiners Report, September 2011 the cost of providing the maturity guarantee allowances for tax transfers of profit to shareholders the costs of any capital necessary to support contracts in the early years a contribution to the free assets, which, in turn, support the smoothing of bonuses and the ability to exercise greater investment flexibility. The asset share can be calculated recursively on a year to year basis. Initially the earned asset share is zero. Each year the cash flows (as listed above) are recorded. A suitable rate of return on investments is used to accumulate the asset share at the start of the year plus cash flows arising during the year end, in order to determine the asset share at the end of the year. This question was reasonably well answered, with candidates finding the standard bookwork contained in part (iii) easier to answer than parts (i) and (ii). One common mistake in part (i) was to fail to tailor the answer to consider the conventional with profits product, referred to in the question, and the fact that experience is shared with the policyholder through bonuses. 4 (i) Embedded value: Shareholder Net Assets = = 700 [Alternatively, net assets, including deduction of solvency margin = = 500] The projected charges and expenses are as follows: Time t Unit reserves (t) charges Expenses Net cash flow ½ = ( ) 75% 1.1 = ( ) 50% 75% 1.1 = The present value of these at 12% is ½ ½ ½ = 87 Now need to allow for the release of non-unit reserves and cost of capital: The non-unit reserves are released as follows: Time t Interest on non unit reserves (t) Reserves released Total cash flow (1.1 ½ -1) = = = The present value of these at 12% is: ½ ½ ½ = 291 Page 8

81 Subject ST2 (Life Insurance Specialist Technical) Examiners Report, September 2011 It can be seen that the cost of capital for the non-unit reserves is: = 3% The cost of the locked in solvency margin is therefore 3% 200 = (6) Therefore overall the total shareholder value resulting from release of non-unit reserves and cost of capital = = 285 [Alternatively, if solvency margin was deducted from s/h net assets, then this should also include release of solvency margin = = 485] For example, one alternative approach is: Projecting forwards the total of non-unit reserves and solvency margin together, and calculating the value of their joint release as ½ 1.12 ½ ½ ½ ½ ½ = 485 From which then need to deduct the value of the solvency margin if this was not deducted from net assets, giving total of 285 as per above (or leave at 485 if solvency margin has already been deducted from net assets). Therefore total EV = = 1,072 [Or EV = = 1,072] (ii) The calculation model now needs to project future bonuses, which will likely be based on the projection of future asset shares. It will need to make assumptions as to when profits are distributed as bonuses and in particular whether they are distributed as regular annual bonus or as a terminal bonus, which could make a difference to the timing and hence the value. The future bonus assumptions will need to take into account policyholders expectations (for example smoothing), which may be influenced by past practice. Where the net assets include the excess of asset shares over the reserves then the value to shareholders for this would be in respect of future projected bonuses from these assets in line with how the company believes these will be distributed to the existing policyholders, and this should be consistent with how the rest of the value of in force is calculated. In addition any net assets in a ring-fenced with profits fund over and above the asset shares may not be valued at the full face value; this may also have to be divided between policyholders and shareholders. As these are not clearly attributed to any individual policyholders (unlike the asset shares), the company will need to make assumptions about when this may be released into profit. Similarly, the release of the solvency margin may also not be 100% worth of value to shareholders, it could be that this also needs to be divided between policyholders and shareholders by projecting the release as bonuses. (iii) For unit-linked contracts, more prudence in the reserving basis would increase the non-unit reserves and decrease net assets, but the value of in force would Page 9

82 Subject ST2 (Life Insurance Specialist Technical) Examiners Report, September 2011 increase as this extra prudence is released in the future. If the company takes the net assets at face value without any lock in, then the overall EV would reduce by the cost of holding the additional reserves, since the discount rate exceeds the earned rate. If the company treats all the net assets as locked in already the increased prudence would not make any difference. For with profits business, the company should be projecting the expected bonuses based on asset shares. Any release of prudence in the reserves which are more than required to cover the bonuses driven by asset shares would be subject to management discretion in terms of how or when it is distributed.in effect this is no different to the treatment of the excess of the assets less the liabilities, and is unlikely to make a material difference to the EV. Generally this was poorly answered across all three parts of the question. In part (i) there are a few ways in which the embedded value could be constructed but many candidates struggled to provide an answer. In part (ii), few candidates were able to provide the required level of detail and as a result this was the worst answered question on the paper. For part (iii), some candidates were able to consider the impact on the unit-linked product, but few were able to extend this to the with profit product. 5 (i) Assumptions: Unit growth rate (p.a.) Valuation interest rate (based on assets backing non-unit reserves) Amount of annual charge on initial units that will be actuarially funded Maintenance expense (p.a.) Claims expense Investment expense (maybe a reduction from amc) Mortality Number of switches per annum Switch cost (if not included in investment expense) Renewal commission Expense inflation rate Average annual management charge Paid-up rates Surrender rates Premium reduction rates Tax (ii) Obtain in-force extract of premium paying and paid-up policies at the beginning of period and end of period including policies written during the year. Obtain data file of all full surrenders and paid-up/premium reduction changes. Deaths and maturities will be excluded. It is usual to exclude switches from policy level investigation. Page 10

83 Subject ST2 (Life Insurance Specialist Technical) Examiners Report, September 2011 Subdividing data the data may be split by: Movement type (full surrender/paid-up/premium reduction). Duration in-force Sales method Premium/benefit level (including policies where no premiums are being paid) Premium payment method Original premium paying term of contract Sex/Age There may be a requirement to split the data into fund type as well. However, the number of different cells investigated will depend on there being sufficient credibility of data within each cell. For each homogeneous group, there will be a need to calculate a surrender rate, a paid-up rate and a premium reduction rate based on experience over the year. The number of contracts that survive in-force to the first policy anniversary in the company s last financial year is divided by the corresponding number of contracts issued, to give a first year persistency rate. The first year surrender rate can be determined as one less the persistency rate. A similar procedure can be adopted to obtain surrender rates for subsequent years. Given policies cannot be made paid-up in the first year then there is no need to calculate a separate paid-up rate in the first year, however for subsequent periods this would be calculated as the number of policies made paid-up over the year divided into the number of premium paying policies over the policy year. For premium reductions (that result in the policy not being made fully paidup) the level of premium reductions would be divided into the total premiums on policies that were in-force and premium paying at both the beginning and end of the investigation period. (iii) Possible reasons: Economic conditions: there may have been difficult economic conditions over the past year and policyholders decide that they can no longer afford the premiums. There may have been poor investment performance, either across the market or specifically within funds offered by this company. There may have been poor publicity for the company, the product, weakened financial strength,or poor administration / customer service. There may have been an increase in mis-selling, whereby products have not fully taken into account policyholders needs or there may have been a similar industry-wide issue affecting all companies. Competitors may have launched different products that have attracted policyholders or similar products with significantly lower charges. Page 11

84 Subject ST2 (Life Insurance Specialist Technical) Examiners Report, September 2011 If charges are variable, they may have been increased. Insurance intermediaries may have been encouraged to move business through differences in commission structures. The company may have sold a large cohort of business which is now in the early years of the contract where surrenders are likely to be higher, hence increasing overall withdrawals. Further, this cohort may have been sold by a particular distribution channel or distributor with poorer than average persistency. There may have been recent changes to legislation or tax. Part (i) was generally well answered as it was a standard book work question, although, some candidates failed to be able to distinguish between data items and assumptions. Despite part (ii) being a book work question, the quality of the answers were disappointing. Candidates in general were able to provide a reasonable variety of reasons for the poor persistency. 6 (i) Take account of PRE. Not exceed earned asset shares, in aggregate, over a reasonable time period. At early durations not appear too low compared with premiums paid. Take account of projections provided at new business. Take account of surrender values offered by competitors/auction. At later durations be consistent with projected maturity values. Not be subject to frequent change, unless dictated by financial conditions. Not be too hard to calculate, taking in account computing power available. Be capable of being documented clearly. May need to ensure it will gain regulatory approval. Maintain equity between exiting and remaining customers. So profit taking should be consistent between exiting and remaining customers. Discontinuities in value by policy term should be avoided. (ii) Retrospective: This is the accumulation of premiums less expenses and cost of cover provided. It may use earned asset share, but not necessarily. So it may be calculated using a formula and parameter values. The starting point for the basis would be actual experience to date for mortality, interest, expenses. Prospective: This is the value of future benefits and expenses, net of future premiums. It uses estimates of future expected experience. Both approaches allow for a deduction of cost of surrender. (iii) Retrospective approach is better in early years as it allows for actual expenses incurred and is comparable with premiums paid, whereas prospective approach is unlikely to be. Page 12

85 Subject ST2 (Life Insurance Specialist Technical) Examiners Report, September 2011 Prospective approach is very sensitive to small basis changes. Over time the retrospective approach is less valid since it doesn t reflect the profit the company would have made if policy stayed in force. So is hard to maintain equity between policyholders who stay and those who leave and hard to maintain equity between surrendering policyholders and shareholders. The prospective approach is better in the later years since it allows the company to quantify how much profit to retain. The retrospective method is unlikely to run into maturity value and unlikely to be consistent with auction values, whereas the prospective method will meet both these criteria. The prospective method is easy to calculate since it requires no knowledge of past experience, whereas the retrospective method will require historical data. The method is likely to be consistent with that used by competitors. (iv) The profit retained by the company is equal to the earned asset share minus the surrender value paid. The basis used to set the surrender values has not been updated since launch so the driver of the lower profit must be the asset share being lower than expected. Possible causes of this are: (a) (b) Investment return Investment returns may have turned out lower than anticipated. The company is very likely to have backed the liabilities with fixed interest investments, matched by term where possible. Yields may have risen during the period and so the capital value of bonds would have fallen, and the earned asset share ( EAS ) would have reduced, but the SV basis has not been changed to reflect this. The approach used to calculate the surrender value scale may have been on a flat yield curve, or single point on the curve, which was not reflective of reality. If corporate bonds were used to match the products then higher than expected defaults or widening credit spreads will have reduced the EAS. Expenses The company s expenses may have been higher than expected. Possible causes may include regulation changes, one-off projects or lack of control over budgets. More policies surrendering than expected will increase the per policy expenses on the remaining policies. Higher surrenders than expected may have been caused by misselling or lapse and re-entry problems, or economic conditions. Page 13

86 Subject ST2 (Life Insurance Specialist Technical) Examiners Report, September 2011 Lower than expected new business volumes could have resulted in higher per policy expenses than expected. (c) (d) (e) Inflation Expense inflation may have been greater than anticipated. Mortality Mortality within the in-force portfolio may have been heavier than in the surrender basis. This may have been caused by out of date assumptions used. Or not accurately enough reflecting the mix of business expected to sell. Other The tax regime may have changed against the company. Mix of surrenders is different. E.g. higher early surrenders when asset share is negative. Or more small policies surrendering. Data or model error. (v) Possible ways to improve the profit made on surrender: Review the surrender value basis periodically (if the terms & conditions allow). For example, update the SVs based on current market conditions. Reduce the current SVs if possible. For example, by increasing/decreasing the expense assumptions in the retrospective/prospective values. Consider how detailed by term the SVs are and make them more detailed if possible. Introduce new SVs which calculate both a prospective and retrospective value and pay out the minimum. Compare the SVs to current auction values and competitor terms to identify particular durations where there is the most scope to increase the surrender profit margin. Candidates were able to reproduce the list in part (i) of this question and to provide the basic description of the retrospective and prospective surrender value methods. Candidates started to find it more difficult to explain why a blended approach might be used in part (iii). Candidates struggled to apply higher level skills in part (iv) when considering reasons why the surrender profit was lower. Some candidates failed to realise that the cause was due to the asset share rather than the surrender basis, which had not changed and so could not be different to that expected. In part (v) most candidates were able to identify paying lower surrender values, but little else. END OF EXAMINERS REPORT Page 14

87 INSTITUTE AND FACULTY OF ACTUARIES EXAMINATION 19 April 2012 (pm) Subject ST2 Life 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 seven 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 from the approved list. ST2 A2012 Institute and Faculty of Actuaries

88 1 (i) Describe how stochastic simulation could be used to value a guaranteed annuity option. [4] The government has recently introduced rules which require that any future annuity rates for newly purchased immediate annuities must be the same for males and females. This change will not affect the terms of existing guaranteed annuity options. (ii) Discuss how this might affect how a life insurance company determines future take up rates for guaranteed annuity options on existing products. [7] [Total 11] 2 A small life insurance company with limited free assets is due to launch its first with profits product. It will be a conventional with profits product with surpluses distributed using the additions to benefits method. The marketing director has proposed that the product should have a high proportion of regular reversionary bonus and a low proportion of terminal bonus, and that it should have a high equity backing ratio. Discuss the marketing director s proposals. [12] 3 (i) List the factors which can influence the unit price of an equity based internal unit-linked fund. [5] (ii) Describe the risks associated with unit pricing, from the perspective of a life insurance company. [8] [Total 13] 4 A life insurance company with a well-recognised brand sells individual term assurance business via the internet. (i) Describe why this distribution channel is appropriate for this product. [3] The company uses insurance intermediaries to sell group term assurance business to employers. The company is considering selling its individual term assurance business through insurance intermediaries, in addition to through the internet. (ii) Discuss this proposal. [10] [Total 13] 5 (i) List the categories into which benefit payments can be split for the purposes of asset-liability matching analysis. [2] (ii) Discuss a suitable investment strategy for the following products: (a) (b) An index-linked immediate annuity. A 25 year conventional with profits endowment assurance that has been in force for ten years, where surpluses are distributed under the additions to benefits method. [14] [Total 16] ST2 A2012 2

89 6 A life insurance company sells immediate annuities. (i) Describe the main features and uses of this product. [7] The company is about to perform the supervisory valuation of these immediate annuities. (ii) Describe the valuation assumptions that will be required. [7] [Total 14] 7 A relatively new life insurance company sells a single premium unit-linked whole life assurance product. The product is sold to very high net worth individuals for inheritance tax planning. It is sold using insurance intermediaries, who are remunerated by a commission payment at the point of sale. The policyholder may choose from a wide range of internal unit-linked funds, and may switch between funds at any time. Other product features are: Benefits: On death the estate receives the value of the unit fund plus an additional fixed sum assured which is defined at outset, minus a deduction of any outstanding initial charges (see below). On surrender at any time, the policyholder receives the value of the unit fund, after deduction of any outstanding initial charges (see below). Partial withdrawals may be taken at any time, subject to a maximum amount per annum and a charge expressed as a percentage of the amount withdrawn. Charges: A per policy initial charge, which is applied quarterly for the first five years and taken by cancelling units. The charge is subject to inflationary increases based on an index specified by the company. A fixed annual management charge, expressed as a percentage of the value of the unit fund. A switch charge, based on the value of the unit fund being switched. (i) Discuss the risks to which the company is exposed in writing this product. [13] (ii) Describe the types of reinsurance that could be used to mitigate some of these risks. [8] [Total 21] END OF PAPER ST2 A2012 3

90 INSTITUTE AND FACULTY OF ACTUARIES EXAMINERS REPORT April 2012 examinations Subject ST2 Life Insurance Specialist Technical Purpose of Examiners Reports The Examiners Report is written by the Principal Examiner with the aim of helping candidates, both those who are sitting the examination for the first time and who are using past papers as a revision aid, and also those who have previously failed the subject. The Examiners are charged by Council with examining the published syllabus. Although Examiners have access to the Core Reading, which is designed to interpret the syllabus, the Examiners are not required to examine the content of Core Reading. Notwithstanding that, the questions set, and the following comments, will generally be based on Core Reading. For numerical questions the Examiners preferred approach to the solution is reproduced in this report. Other valid approaches are always given appropriate credit; where there is a commonly used alternative approach, this is also noted in the report. For essay-style questions, and particularly the open-ended questions in the later subjects, this report contains all the points for which the Examiners awarded marks. This is much more than a model solution it would be impossible to write down all the points in the report in the time allowed for the question. T J Birse Chairman of the Board of Examiners July 2012 Institute and Faculty of Actuaries

91 Subject ST2 (Life Insurance Specialist Technical) April 2012 Examiners Report General comments on Subject ST2 The Examiners Report covers more points than would be expected to get full marks. This is so that alternative approaches to questions by different candidates can be accommodated within the marking scheme. Candidates are expected to show knowledge of the relevant content of the Core Reading, but those who tailor their answer to the specifics mentioned in the question will score more highly than those who answer in a more generic way. Comments on the April 2012 paper As usual, questions that focussed on knowledge of the Core Reading were well answered. Higher marks were scored by those that could apply that knowledge to the situations described in the questions (for example, see the comments on questions 1 and 4). There were cases where candidates did not read the question properly and gave irrelevant answers (for example, see the comments for questions 2 and 3) or were too generic in their responses without giving the correct level of detail and missing easy marks (see the comments for question 6). Candidates should use Examiners Reports to practice applying their knowledge to the situations set. Page 2

92 Subject ST2 (Life Insurance Specialist Technical) April 2012 Examiners Report 1 (i) A stochastic model of rates of return on investments is used to simulate the future price of assets. The assumptions underlying the model must be carefully evaluated to ensure that they correspond to the company s planned investment strategy during the phase before the guaranteed annuity option is exercised. A large number of simulations are needed in order to obtain reliable estimates. The guarantees depend on future market conditions and so factors influencing the value of the liabilities as well as assets will need to be simulated; in particular interest rates at the time of exercise will need to be simulated. The company will need to make assumptions regarding expenses and mortality which would need to take account expected experience. The company will also need to make assumptions about future rates of exercising options, which would take into account expected policyholder behaviour and the size of the guaranteed amount relative to asset share. Allowance should be made for interactions between assumptions. The present value of the liability can be determined by discounting the simulated cost of exercising the option at a suitable rate. The cost of exercising the option is the difference between the fund at term and the price of the annuity guaranteed. Repeated simulation will generate the probability distribution of the present value of the cost of the option. A best estimate valuation would be based on the average of the simulations. A margin may be added, or a higher confidence level taken, depending on the purpose of the valuation. (ii) Policyholder behaviour depends mainly on whether a higher annuity than is implicit in the guaranteed annuity can be bought in the market. The main reason for such a difference is likely to be investment conditions, but mortality assumptions will also contribute. In order to harmonise the annuity rates, companies are either going to: increase the annuity that a female will get for a given premium and reduce rates for males or they may just leave female rates the same and reduce male annuity rates Different companies may take different approaches, but competition is likely to be a key driver, and so there is likely to be some consistency between companies. This uncertainty makes projecting whether or not the GAO is valuable to the policyholder more difficult. In addition, there may now be more difference in take up rates between males and females. For example if market rates for males become more expensive, the take up rates for males could increase because the GAO could now be exercised due to this issue as opposed to being due to investment conditions. Or for example if female annuity rates mean that it is cheaper to buy an annuity in the market, then take up rates could decrease even if investment market conditions would suggest otherwise. Page 3

93 Subject ST2 (Life Insurance Specialist Technical) April 2012 Examiners Report Importantly, take up rates are no longer mainly dependent on what it costs the company to pay the annuity (as this cost does not change due to the rule change), but rather they depend on the potential distortion between market premiums and actual costs. So for example the company could find take up rates for females decreasing, even if the actual cost to the company of paying the guaranteed annuity is increasing. With all the complexities involved, the company will need to monitor what the market is doing and use this to inform it of potential take up rates. The decision may depend on the split of males and females within the current and target future market. The question implies there is a difference between male and female mortality. The solution assumes that female mortality is lower than male. Marks were given where the opposite was assumed and stated, but arguments needed to be internally consistent to gain full credit. In part (i) the majority of candidates were able to describe the mechanics of stochastic modelling and the better candidates applied this to GAOs defining the cost to the company correctly. Part (ii) was not generally well answered with many candidates missing that existing GAO terms were not affected and also discussing how new annuity take up rates would be affected. Most lacked the higher level insight to score well with only the stronger candidates considering the items that impact the customers take up decision. 2 Once reversionary bonus has been allocated to a policy it cannot be taken away, whereas terminal bonus gives the company more flexibility. The marketing director s suggestion regarding bonus balance will therefore mean that the guarantees on the product will be high. This will increase the marketability of the product if policyholders prefer guarantees. Therefore, high sales volumes, and hence profit, may be possible depending on how the product compares to its competitors. Also, the company s shareholders may want to have the profit distributed as soon as possible and so would like the higher reversionary bonus proposal. The guaranteed benefits will be broadly matched by fixed interest assets and discretionary benefits will be matched by assets providing a real return (e.g. equity/property) However, having a high proportion of reversionary bonus and low terminal bonus accelerates the distribution of surplus and would be expected to increase the reserving requirement. This is not good given the company has low free assets. A higher equity backing ratio will ordinarily lead to higher payouts. A high equity backing ratio means that the returns and the asset share will be more volatile than if an investment strategy of investing in gilts was used. This means there is an increased risk for the company of the asset share at maturity being lower than the guaranteed benefits under the policy. The shortfall between the asset share and the guaranteed benefits would need to come from the company s free assets, which are limited and hence may threaten solvency. As the company has only limited free assets, it may not be able to take this level of risk through use of smoothing or mismatching reserves Page 4

94 Subject ST2 (Life Insurance Specialist Technical) April 2012 Examiners Report The company could charge for the guarantees or pay less than asset shares at other times, to meet the cost over time, but this does not remove the short term risk of the volatile returns. A high equity backing ratio will mean that the assets backing the liabilities will be volatile, which may significantly increase the reserves, further reducing the company s limited free assets. Overall, the two aspects of the proposal do not fit well together and the company may need to consider offering just one or the other or use a compromise between the two. The decision may depend on the specific target market (which may expect high levels of guarantees), which itself may depend on the distribution channel chosen. For example insurance intermediaries may have more financially sophisticated customers who may prefer a high EBR. The company may need to consider whether there are any regulatory restrictions that would relate to these proposals and would need to consider the importance of avoiding setting unrealistic policyholder expectations, e.g. it could not start with a high reversionary bonus strategy and then decide to change this if things went wrong, if it had publicised the product as having such a strategy. The company has limited experience in with profits business and hence may adopt a more cautious approach. A fairly well answered question with the majority of candidates identifying that high regular bonuses conflicted with high EBR. Better answers considered the pros of the suggestion as well as the cons. A sizeable proportion of students described the different bonus distribution mechanisms which wasn t required by the question and hence scored few marks. 3 (i) Equity market movements to the extent that they affect this unit-linked fund. Dividend receipts. Purchase/sale expenses incurred from buying/selling. Amount of current assets/liabilities in the fund. Accrued tax. Approach taken to rounding. Initial charge on purchase/allocation of units to cover management expenses, commission and profits. Annual management charge. Whether pricing is on a bid or offer basis, which itself depends on the relative levels of cashflow into or out of the unit fund over a reasonable period. Foreign exchange rates if underlying assets are in a different currency to that used in pricing the unit linked fund. (ii) The company could be out of the market too long between receiving money and the unit price being allocated. So the company exposes themselves to either complaints from customers (if they do not receive the unit price they expected) or market movements between the price they allocate and the price they actually get. This can equally apply to surrenders. Page 5

95 Subject ST2 (Life Insurance Specialist Technical) April 2012 Examiners Report Time lags can be exploited by policyholders or sales people, if they can trade units at a price which is based on known market movements. The initial charge taken may not be adequate to cover management expenses/commission etc and annual management charges may be insufficient to cover ongoing administration expenses. The tax may be determined incorrectly and not treat all policyholders fairly. In addition the tax allowed for in the fund may not reflect the tax position of the company. The company may not move from offer to bid basis at the right time so policyholders get the wrong unit price (which again could lead to complaints) or the company itself suffers a loss. There may be a mass exodus from a particular unit fund which the company had not anticipated, resulting in the unit price not reflecting the sale expenses appropriately. Or the company may not be able to liquidate the underlying assets quickly enough or may have to liquidate at a lower price to pay for these high surrender claims. This is a particular risk in a fund investing in illiquid assets where the unit pricing may include a stale price e.g. property The unit price may be miscalculated, either on a specific day or over a period of time. This could be due to inadequate documentation or controls. Where the error is not in line with the terms and conditions the company will need to compensate policyholders. If the errors recur and customer service suffers, there may also be a related reputational risk. Which could adversely impact new business volumes or lead to higher lapses. There may be a regulatory/compliance risk that processes and practices maybe changed as a result of changes in regulations or guidance Part (i) was reasonably well answered with candidates who focussed on the specifics of the fund scoring well. Some candidates listed factors affecting the general economic environment (e.g stockmarket falls), and marks were only given for these comments where candidates indicated how these might affect a specific unit fund. Part (ii) was poorly answered with many candidates discussing the risks of a unit linked product rather than the pricing of a unit fund and others considered only a narrow set of points. Only the better candidates thought widely enough to score well in part (ii). 4 (i) Individual term assurance is a simple product: a set premium for a set benefit over a set period. For the customer, the main decision will be based on price. As internet is a low cost distribution channel, it will suit a product sold primarily on price. The internet is appropriate for simple products As the company is a recognised brand, customers looking to buy this product are likely to visit the company s website. Customers are likely to trust purchasing this product from a recognised brand. Page 6

96 Subject ST2 (Life Insurance Specialist Technical) April 2012 Examiners Report If the customer is also able to complete the purchase via a simple online process, then this will be an effective channel. The company may have a simplified underwriting process that allows this. (ii) This is an additional channel and hence should increase sales and potentially profits. The company already uses insurance intermediaries and so will not have to incur significant set up costs to add this channel to its individual term assurance product. However, there will still need to be systems changes made. It may be that the insurance intermediaries it uses currently are not active in the individual term assurance market. The target market is likely to differ between the two types of distribution channel, so the company may have to reconsider its pricing assumptions and decide whether to price differently for the new channel. It is likely that the customers of insurance intermediaries are more affluent and financially sophisticated. Therefore mortality may be lower due to the higher socioeconomic class. Persistency assumptions are also likely to be different. Potentially there may be higher initial anti-selection risk and higher selective withdrawals in the business sold by insurance intermediaries. It is likely that the level of underwriting will need to increase for the customers of insurance intermediaries. The current level of underwriting (used for the internet sales) is likely to lead to premiums that are too high in the intermediary market, so the company will need to increase underwriting to allow premiums to be competitive. The company needs to consider whether it has the necessary underwriting skills. The company will have to decide on the appropriate level of commission to the intermediary and the structure of that commission. High initial commission might mean that the product will have higher capital strain through this proposed new distribution channel. The potential higher costs both of distribution and underwriting will need to be considered. It may be that the average policy size will be significantly higher than for the business through the internet. The company may need to review its reinsurance arrangements to reflect the differences. The lack of comparison with other companies on the website may mean that the company can write internet business on very profitable terms. These premium rates may not be competitive in the insurance intermediary market and insurance intermediaries aim to find the best contracts in terms of benefits and premiums for their clients. The company will need to consider whether, given the potential differences in pricing assumptions for the new channel, it can compete in the insurance intermediary market with reduced profit margins. Whilst still achieving the desired profitability. This approach may be in response to similar action by competitors or in order to achieve a competitive advantage. Page 7

97 Subject ST2 (Life Insurance Specialist Technical) April 2012 Examiners Report The mis-selling risk will change, although part of this risk will fall onto insurance intermediaries. As the company will have less control over the sales process. In addition, there may be greater risk in pricing as the company will not have experience data (mortality, persistency) for this target market and product. There will be increased counterparty risk from the potential of intermediaries not paying premiums The company could consider alternative distribution channels or methods (e.g. mailshots, or via other existing channels it may already use) A fairly well answered question in both parts. A minority misunderstood the question and compared selling group policies to selling individual policies. The stronger candidates realised different levels of underwriting would be required for the IFA channel and with larger policy sizes could lead to better profit. Most candidates produced an answer considering a number of different points for part (ii). 5 (i) Guaranteed in money terms Guaranteed in terms of an index of prices or similar Discretionary Investment-linked (ii) In general the assets should reflect the nature, term and currency of the underlying liabilities. (a) The benefit is guaranteed in terms of an index. Ideally invest in an asset whose return is linked to the same index as the benefits. If no assets linked to that specific index are available then use a similar index, e.g. CPI and RPI indices. Would want to match asset and liability cash-flows by term. So, buy corporate or government index-linked bonds. The return is higher on corporate bonds but they introduce credit risk so this would be subject to risk appetite and any credit risk policy the company has. However, there may not be a sufficient amount of index-linked bonds available, especially of long enough term to match an annuity. An alternative is to invest in real assets (e.g. equity/property) as they can provide a real return and match longer terms but this increases default and liquidity risks. Another alternative is to buy fixed rate bonds, corporate or government, with a fixed to floating swap overlaid. This introduces the use of a derivative so may be restricted by the company s policy on investment in derivatives, and is also more complex. It is likely that some cash would be required to top up any payments not met by the bond coupons. There is a related expense reserve, which would also broadly be linked to an index, so should be matched by similar assets to the benefits. Or possibly may Page 8

98 Subject ST2 (Life Insurance Specialist Technical) April 2012 Examiners Report consider equities if the expected rate of expense inflation cannot be matched by an asset linked to a suitable index. A final consideration should be whether there are any valuation rules or other regulatory restrictions. (b) The benefit is guaranteed in money terms in respect of base sum assured and ten years bonuses declared to date. It is a discretionary benefit in respect of future reversionary and terminal bonuses. Investment options are likely to be restricted by PRE, for example, what the company has told the policyholder in its sales and other product literature. Fixed rate bonds could be suitable to back the sum assured and bonuses declared to date; corporate or government will depend on the risk appetite of the company. The term of the bonds should match the outstanding duration of the policy (i.e. 15 years). The overriding principle for investment to provide future bonuses is to aim to maximise the return. Choice of asset to provide future bonuses will be dependent on the bonus policy, e.g. the split between future regular and terminal bonus. A mixture of equity and property is most likely for future discretionary bonuses. The amount of free assets will also determine the amount of investment freedom the company has. Lower free assets would usually mean a higher proportion of bonds or vice versa. As the policy moves through its term and more bonuses are declared, investment would shift away from equities and into bonds. The company would also consider the investment mix offered by competitors. Most candidates scored full marks for the bookwork in part (i) however few then applied this in part (ii) to the specific products. Though a relatively simple question there were a surprising number of candidates who did not score well due to straying too far from a wellmatched investment strategy or not covering the investment options in enough depth. In general candidates who used nature, term, currency as a structure produced better answers. 6 (i) An immediate annuity is a contract to pay out regular amounts of benefit provided the life assured is alive at the time of payment. The contract starts payment immediately without a deferred period. Payments may be made in advance or in arrears, with the maximum period to the first payment being the frequency period of payment. The contract is purchased in advance by a single premium, where this premium may be the proceeds of another contract. A country s pension legislation may specify that an annuity must be purchased from part or all of a pension fund accumulated to the retirement date. Page 9

99 Subject ST2 (Life Insurance Specialist Technical) April 2012 Examiners Report For the consumer the contract converts a capital sum into a lifetime income, removing the uncertainty of how quickly capital should be spent to provide income over the consumer s remaining lifetime. Immediate annuities may be purchased on single, joint life first death or last survivor bases. A last survivor annuity can be used to provide for dependants income following the death of the main life. Immediate annuities can be payable for temporary periods only, making them suitable, for example, to pay the school fees of the insured s children. The regular benefit payments may be level or variable, the most common variable being a fixed or inflation linked increase. An option may be available for the payments to be made for an initial number of years irrespective of whether the life insured survives the initial period. Alternatively, there may be a guarantee that, on death within a specified period, any shortfall between the initial premium paid and the amounts of annuity received to the date of death will become payable. Surrender values are not normally payable. Different versions of the product may be offered e.g.an impaired life annuity, 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, a unit linked version or a with profits annuity. (ii) In general, the assumptions used to determine the liabilities should have regard to the legislation and accounting principles governing the preparation of those accounts in the country concerned. All of the assumptions should be prudent, including an appropriate margin against adverse deviation. Mortality Assumptions will be required for the base mortality level and for the level of expected future mortality improvements. The assumptions chosen should have a regard to the country where the annuitants live. The prudential margin would be a reduction in base mortality, and faster future mortality improvements. Expenses An allowance for expenses should be included which should reflect expenses expected to be incurred in administering the annuities. Allowance may also be made for a share of future expected overhead expenses. The prudential margin would be an increase in expenses. Page 10

100 Subject ST2 (Life Insurance Specialist Technical) April 2012 Examiners Report Inflation An explicit assumption will be required to allow for the future inflation of expenses. It may also be required to allow for the future inflation of benefits, if the annuity is index-linked. The inflation assumptions could be based upon the: current rates of inflation, for both prices and earnings expected future rates of price and earnings inflation differential between the return on government fixed interest securities and on government index-linked securities, where they exist recent actual experience of the life insurance company or industry The prudential margin would be an increase in inflation. Valuation rate of interest A valuation rate of interest will be required which should have regard to: the yields on corresponding existing assets the level of default risk for corporate bonds a level of reinvestment risk A prudential margin could be included which would reduce the valuation rate of interest. Taxation An allowance for taxation will need to be included as an assumption either explicitly or implicitly within the assumptions for valuation rate of interest or other assumptions. The bookwork in part (i) was well answered with most candidates covering the main features and uses. The most common omissions were that increasing annuities could be with a fixed or index-linked increase and distinguishing between the two different joint life options. In part (ii) most candidates identified the main assumptions required and many stated that they should be prudent but few continued to explain what prudent meant in practice. As a result a number of relatively easy marks were missed. Many candidates also confused the assumptions for valuation interest rate, risk discount rate and future investment returns. 7 (i) Investment Performance The annual management charges are dependent on the investment performance and hence may not generate sufficient income if investment performance is lower than expected in pricing. This is also true for the withdrawal charge. This is a particular issue because the unit-linked funds are Page 11

101 Subject ST2 (Life Insurance Specialist Technical) April 2012 Examiners Report chosen by the policyholder, and hence the company has limited control over the choice of those assets. Expenses/Charges There is a risk of higher than expected administration expenses. Expense risk is greater as a result of the annual management charge being fixed and not variable. There may be a risk of higher than expected inflation if the increase in fund value (and hence annual management charge) does not keep pace with expense inflation. Conversely, if inflation is lower than expected the initial charges may be lower than expected and not recover the actual initial costs. The initial charges are deducted from the value of units, hence there may be related liquidity risk. There is a risk that the charge for switches does not reflect the actual costs involved in switching units. Mortality Because the additional sum assured is a fixed amount, there is a risk of earlier deaths than expected. The relative size of this risk depends on the level of additional fixed sum assured applied. Anti-selection may be worse than expected depending on the extent of underwriting undertaken. Withdrawal/surrender There is some risk of higher than expected withdrawals, particularly early on. The outstanding initial charge is deducted on surrender, which reduces this risk depending on the extent to which the initial charge covers the initial expenses and commission for this product. Higher than expected surrenders will reduce the generation of future profits. There is also a risk of the level of partial withdrawals being higher than expected in pricing which will potentially expose fixed expense levels and hence reduce profits. Selective withdrawals may be possible if the fixed additional death benefit is relatively large. New Business Volumes There is a risk of new business volumes being significantly higher than expected during any particular period. This could cause administration strain and it could cause capital strain and risk of insolvency. This is particularly the Page 12

102 Subject ST2 (Life Insurance Specialist Technical) April 2012 Examiners Report case here because new business strain could be high, depending on the regulatory reserving requirements, due to the initial expenses and commission being larger than day one charges received. As the initial charge is not unitrelated it cannot be actuarially funded, but credit for that charge could be included in non-unit reserving calculations, but only to the extent that local regulations permit (e.g. the local regulations may not permit negative non-unit reserves). There is also a risk of significantly lower than expected new business volume which exposes the company to expense risk, with fixed overheads possibly not being covered by charges. New Business Mix Since many of the charges are related to the size of fund, there is a risk that smaller than expected policies are sold. There is also a risk that the assumed mix by age of policyholder is different from that expected, especially as there is no explicit mortality charge. Reputation Deducting the outstanding charges on death, and explicit partial withdrawal charges, may be unusual and could generate a reputational risk. The product could be mis-sold or churned by some insurance intermediaries. Other There is a risk of policyholder fraud, e.g. money laundering. There is a legal risk if policy conditions are not appropriately worded. There is a risk of changes to the regulatory or tax regimes, e.g. inheritance tax changes may reduce the attractiveness of the policy. There is the risk of actions of competitors, e.g. launching a similar product and stealing market share There will be an operational risk of unit pricing errors, and given this a new company this risk may be high. There is a risk of failure of appropriate management systems and controls. If the company uses reinsurance, there is the risk of failure of the reinsurer. There is also some credit risk as a result of intermediaries not paying premiums to the insurer this increases the risk relating to the recovery of expenses and profits. (ii) Reinsurance is most likely to be used to mitigate the: Mortality Risk To mitigate the mortality risk, would likely reinsure only the sum at risk i.e. the fixed additional sum assured. This is because it is difficult to obtain agreement to reinsure unit-linked benefits to which the reinsurer has no link. Page 13

103 Subject ST2 (Life Insurance Specialist Technical) April 2012 Examiners Report Original terms reinsurance is unlikely to be viable because there is no separate premium/charge made for the fixed sum assured. Most likely to use risk premium reinsurance where premium rates would be defined by reinsurer and may be guaranteed or reviewable. Could be quota share, whereby a specified percentage of each policy is reinsured, or individual surplus treaty, whereby the reinsured amount is the excess over retention limit. The company could use stop loss reinsurance to mitigate excessive death claims over a defined period. New Business Strain Company is relatively new and would want to limit new business strain and hence could use financial reinsurance. This could be asset enhancing or liability reducing. The asset enhancing version could be via financing commission. In this case it is likely to be asset enhancing, with the reinsurer providing funds that are repaid out of surplus emerging over a specified period. It could be that the initial charges, or a proportion of them, are paid direct to reinsurer as they emerge. Repayment is contingent on surplus emerging, therefore there is no requirement to hold a liability on the balance sheet, but the assets can be included. Both parts were fairly well answered particularly in part (i) where candidates discussed a wide range of risks. The stronger candidates considered the specifics of the question and hence detailed how the risks applied to this particular product. Few candidates spotted that mortality charges would be significant but were wrapped up in the general charge and that the mortality risk was really earlier deaths than anticipated rather than generally higher mortality. When candidates scored poorly it was generally because they only considered a small range of risks and failed to link those risks to the specific product. In part (ii) many candidates identified relevant types of reinsurance, particularly the financial reinsurance aspect, but only the stronger ones pointed out that the unit fund would not normally be reinsured. Very few commented that original terms would not apply as there is no specific mortality charge. END OF EXAMINERS REPORT Page 14

104 INSTITUTE AND FACULTY OF ACTUARIES EXAMINATION 28 September 2012 (pm) Subject ST2 Life 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 seven 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 from the approved list. ST2 S2012 Institute and Faculty of Actuaries

105 1 Discuss the role of solvency projections in a life insurance company. [9] 2 (i) Define the embedded value of a life insurance company. [2] A life insurance company has only ever sold term assurance business. It has just finished analysing its mortality experience for the past year. The conclusion of the study is that mortality has worsened, requiring a change to the company s mortality assumptions. The company uses two sets of mortality assumptions in its embedded value calculation. One set is used to project experience and is realistic; the other is used to calculate future reserves and is prudent. (ii) Explain the impact on the company s embedded value if: (a) (b) (c) the realistic mortality assumptions were increased in isolation the reserving mortality assumptions were increased in isolation both sets of mortality assumptions were increased at the same time. [9] [Total 11] 3 A life insurance company sells a conventional with profits endowment assurance product. Profits are distributed by the additions to benefits method. (i) Describe how the company would determine the terminal bonus rates for maturities for this product. (Description of how to calculate the asset shares is not required.) [5] The company has recently declared its latest terminal bonus rates. Since the declaration, there has been a fall in worldwide equity market values. (ii) Discuss the actions that the company might take with regard to terminal bonus rates. [8] [Total 13] ST2 S2012 2

106 4 A life insurance company has historically only sold single premium unit-linked bonds, with a fixed term of ten years. It is planning to launch a new unit-linked endowment assurance product. The features of both products are detailed below. Current product New product Contract Unit-linked bond Unit-linked endowment assurance Premiums Single premiums Single or regular premiums Term Ten years Various Maturity Benefit Value of unit fund Value of unit fund subject to minimum of guaranteed sum assured Surrender Benefit Value of unit fund, less surrender penalty which is expressed as a percentage of the value of unit fund Value of unit fund, less surrender penalty which is expressed as a percentage of the value of unit fund and is applied during the first five years only Death Benefit 101% of value of unit fund Value of unit fund subject to minimum of guaranteed sum assured Variable annual management charge taken as a percentage of the value of unit fund Charges Allocation rate applied to the premium Fixed annual management charge taken as a percentage of the value of unit fund Commission Percentage of premium Percentage of each premium The company currently uses a deterministic model to project the cashflows for its unit-linked bonds, and this model is used for both pricing and valuation purposes. It is considering how the model would need to be changed if it introduces the new endowment assurance product. (i) Outline the additional features that would need to be included in the model. [7] An external company which provides a standard actuarial model for unit-linked endowment assurances has spoken to the Finance Director about using its model for this new product. (ii) Discuss the considerations for the life insurance company when deciding between amending the existing model and purchasing the new model. [6] [Total 13] 5 (i) List the factors by which data would be subdivided when analysing withdrawal experience, assuming sufficient volume of available data. [4] A life insurance company has just performed a high level analysis of the previous year s withdrawal experience. The experience appears to be significantly worse than expected. (ii) Discuss the possible next steps in response to this analysis. (You are not required to discuss ways in which the actual withdrawal experience could be managed). [12] [Total 16] ST2 S PLEASE TURN OVER

107 6 A life insurance company sells a without profits whole life assurance product, for which premiums are payable annually and the benefit is payable at the end of the year of death. Renewal expenses are incurred annually from the start of the first policy year and do not inflate. Death claim expenses are incurred at the end of the year of death and also do not inflate. The company is considering setting the surrender value using an adjusted retrospective method such that it retains profit equal to the accumulated value of 5% of each premium received plus 5% of the expected value of future premiums payable. (i) Give a surrender value formula which satisfies this requirement. [5] The company has used the following basis to calculate its premium rates: Mortality 100% AM92 Initial expenses 100 Renewal expenses 20 per annum Interest 6% per annum Profit loading 5% of each premium. The actual experience to date has been as follows: Mortality 100% AM92 Initial expenses 95 Renewal expenses 25 per annum Interest (averaged) 4% per annum Death claim expenses 5 Surrender expenses 10 All expense information quoted above is per policy. The company s best estimate future assumptions are currently the same as its actual experience. Consider a policy purchased by a 50 year old at entry for a sum assured of 50,000. The annual premium for this policy is 800. The company has used the surrender value formula in (i) to determine what should be paid to such a policyholder under the proposed approach, if surrender were to occur now after three years in force and also now after 35 years in force. The results of these calculations are 1,200 and 7,000 respectively. The Finance Director has queried these results. (ii) Demonstrate the reasonableness of the three year figure. [5] (iii) Explain why the 35 year figure is negative. [4] (iv) Discuss the extent to which the proposed method fits with the principles for determining surrender values. [6] [Total 20] ST2 S2012 4

108 7 A life insurance company writes term assurance business, for which it uses medical underwriting at the application stage. (i) Describe the medical underwriting process that is likely to be followed by the company. [8] It has been suggested that medical underwriting is a barrier to sales and that the underwriting criteria should be relaxed. (ii) Discuss this suggestion. [10] [Total 18] END OF PAPER ST2 S2012 5

109 INSTITUTE AND FACULTY OF ACTUARIES EXAMINERS REPORT September 2012 examinations Subject ST2 Life Insurance Specialist Technical Introduction The Examiners Report is written by the Principal Examiner with the aim of helping candidates, both those who are sitting the examination for the first time and using past papers as a revision aid and also those who have previously failed the subject. The Examiners are charged by Council with examining the published syllabus. The Examiners have access to the Core Reading, which is designed to interpret the syllabus, and will generally base questions around it but are not required to examine the content of Core Reading specifically or exclusively. For numerical questions the Examiners preferred approach to the solution is reproduced in this report; other valid approaches are given appropriate credit. For essay-style questions, particularly the open-ended questions in the later subjects, the report may contain more points than the Examiners will expect from a solution that scores full marks. D C Bowie Chairman of the Board of Examiners December 2012 Institute and Faculty of Actuaries

110 Subject ST2 (Life Insurance Specialist Technical) September 2012 Examiners Report General comments on Subject ST2 The Examiners Report covers more points than would be expected to get full marks. This is so that alternative approaches to questions by different candidates can be accommodated within the marking scheme. Candidates are expected to show knowledge of the relevant content of the Core Reading, but those who tailor their answer to the specifics mentioned in the question will score more highly than those who answer in a more generic way. Comments on the September 2012 paper As with previous papers, questions that focussed on knowledge of the Core Reading were generally well answered. Questions 6 (ii) and 6 (iii), were, however, often poorly answered. Whilst the report below gives quite a detailed solution, many candidates were unable to cover a wide enough range of valid points. Similarly, answers to questions that required candidates to think more widely, such as 3 (ii), did not show a sufficiently comprehensive understanding. Candidates should use Examiners Reports to practice applying their knowledge to the situations set. Page 2

111 Subject ST2 (Life Insurance Specialist Technical) September 2012 Examiners Report 1 Solvency projections allow a life insurance company to assess its ability to withstand future changes, whether they be economic or company initiated for example assessing the impact of management decisions. They allow the company to assess its future solvency position and its potential future needs for capital injections and to assess the probability of insolvency. They also allow the company to determine the profile of its liabilities in terms of type, amount and duration. The company may perform the solvency projections on either a regulatory or realistic basis. Supervisory calculations often only look at the risks currently run but projections will show how risks change over time. This is especially important where risks increase over time as taking measures to control the risk at its current level would then not be sufficient in future. Projections can also be used to assess how sensitive a company is to particular risks. Solvency projections are also useful in assessing the amount of new business that the company can afford to write and the additional risks this runs. Also they may be used to assess the impact from changing product mix as a result of its new business strategy. By projecting the solvency position on a stochastic economic basis a company can verify whether its current investment strategy is appropriate and assess the level of additional freedom it has. Solvency projection can help with the selection of an appropriate matching investment strategy. Solvency projections can be used in determining the most appropriate bonus level and type to declare for with profits policies. Solvency projections will be vital if a company is considering the closure of a with profits fund. They will produce a runoff profile for the remaining liabilities and hence help establish the most appropriate course of action. Once a risk profile has been determined, possible risk management measures can be tested through solvency projections to ensure they are effective and add value to the company, for example, a change to the company s reinsurance strategy. In some countries, there may be a regulatory requirement to perform projections of future solvency. Candidates did not answer this question as well as would have been expected. The most common problem was that students provided superficial answers or failed to distinguish between current solvency and projecting solvency. A number of candidates described how solvency projections would be performed which is not the role of solvency projections and hence not what was required. Page 3

112 Subject ST2 (Life Insurance Specialist Technical) September 2012 Examiners Report 2 (i) The embedded value is the present value of the future shareholder profit stream from the company s existing business together with the value of any net assets separately attributable to shareholders. (ii) (a) Increasing the best estimate assumption on term assurances means that the company will expect to experience more deaths and by implication higher claim payments than previously anticipated. Higher claim payments will result in lower profits emerging into the future, when compared against the previous realistic mortality assumption. Lower future profits will mean that the present value of future profits element of the embedded value is reduced. There will be no impact on the net asset value element of the embedded value. So overall, the embedded value of the company will reduce as a result of increasing the mortality realistic assumption. (b) Increasing the reserving assumption on the term assurances will result in an immediate increase in the level of reserves held, which in turn will reduce the net asset value of the company. As the reserving assumptions have been increased, but the realistic assumptions have not been, the margin between the two sets of assumptions has increased. This increase in the mortality margin will be released in each future time period, increasing the level of profit and increasing the present value of future profits element of the embedded value. The overall impact is that the net asset value decrease is offset by an increase in the present value of future profits. If the discount rate used in the embedded value calculation is higher than the assumed rate of investment return, as is likely, then the impact of discounting on the future releases of profit means that the embedded value would reduce as a result of increasing just the reserving mortality assumption. If the discount rate is the same as the assumed rate of investment return, then there would be no change to the embedded value. (c) Overall, the impact on the embedded value is likely to be a reduction, and may be similar to that under (a) combined with (b). Page 4

113 Subject ST2 (Life Insurance Specialist Technical) September 2012 Examiners Report If both realistic and reserving assumptions change by the same amount, then the net assets reduce immediately due to the increase in term assurance reserves and the PVFP remains unchanged. The impact on the present value of future profits will depend upon how the margin between the reserving and realistic mortality assumptions changes. If the margin increases then the present value of future profits will increase. For example, this could occur if the reserving mortality assumption was to be set using a 10% margin above the realistic assumption. However, overall it is likely that the margin between the two sets of assumptions will remain broadly the same or that any difference will be relatively small. The present value of future profits is therefore likely to remain broadly unchanged. Part (i) is a standard bookwork definition, which most candidates managed to answer well. In part (ii), the first two parts were generally answered well, the most common problem being that candidates failed to provide enough detail for the marks on offer. Some candidates failed to consider the impact on the net assets and the present value of future profits despite being able to provide the definition in part (i). The final part of part (ii) was not so well answered as most candidates failed to appreciate that the relationship between the reserving and realistic assumptions was important and the two sets of assumptions may not be increased by the same amount. 3 (i) For setting terminal bonus, the company would be interested in policies due to mature in the coming period. It would group them according to similar characteristics, for example, policies of the same term. The combined asset share for the group at the maturity date would represent an equitable payout for that group. This could be determined using the current total asset share for the policies in that group rolled up (using projection assumptions) for the short period to the average maturity date. By comparing the combined asset share to the combined guaranteed benefits (original sum assured plus accumulated reversionary bonuses) it is possible to determine an appropriate average terminal bonus rate, expressed as a percentage of either sum assured or sum assured plus bonuses to date. This would need to be compared to what might reasonably be expected by customers. In particular, the company would need to consider any adjustment required in order to smooth benefits. This could be done either directly to the terminal bonus rates, or through smoothing the asset share, or by adjusting the asset share by smoothing the investment returns used. The company may decide to Page 5

114 Subject ST2 (Life Insurance Specialist Technical) September 2012 Examiners Report adjust the terminal bonus rates further to avoid any potential significant discontinuity in the rates (e.g. between rates applicable to similar terms). The company would need to consider the terms and conditions that may impact the decision, for example, it is likely that terminal bonus cannot be negative. (ii) The impact will depend on the actual returns achieved by the fund. This will be different to the overall equity market change because the fund is unlikely to have been invested fully in equities, though consideration should be given to whether other assets held in the fund are correlated to equities. The company may also have had an effective hedging strategy in place. However, if the fund has experienced falls then the asset shares backing the endowment policies will have fallen. Expert opinion should be sought on whether the fall is temporary or a correction previously accounted for. The company will thus need to consider the current level of payouts relative to the revised level of asset shares. It maybe that, at the recent declaration, payouts were below asset share for smoothing reasons and so now payouts may be back in line with the revised asset shares. So no action on terminal bonus rates need be taken in that situation. However, if payouts are now above asset share, the company may consider reducing terminal bonus rates, unless they are already zero and so cannot be reduced. If the company declares separate final bonus rates that apply on surrender, the company might act more quickly to reduce these rates in order to avoid selection against the fund. Any reduction will be subject to: Disclosures to customers Ensuring that it does not breach their reasonable expectations or other regulatory restrictions The smoothing policy of the company, which will restrict the speed or magnitude of changes in payouts. The size of the free assets, if large, the company may be relaxed about the speed of any change. In particular, the company needs to consider how quickly it can change its terminal bonus rates. Changing them immediately may contravene the contract and so the company would have to wait until the next scheduled terminal bonus announcement date and reconsider the position then, or it may have allowed itself complete flexibility regarding terminal bonus declarations. There are also systems implications, which will mean there will be some delay before new rates can be implemented. Page 6

115 Subject ST2 (Life Insurance Specialist Technical) September 2012 Examiners Report There will also be a need to announce the new terminal bonus rates to policyholders and distributors. The impact on shareholder transfers should be considered as changing bonus rates will affect this. The materiality of the product to the company should also be considered. Many candidates appeared to struggle with this question. In part (i), despite the instruction in the paper for candidates not to provide details on how to calculate an asset share, some candidates still did. Often there was insufficient detail given in answers, taking into account the number of available marks. Candidates generally scored better on part (i) than part (ii). In part (ii), some candidates strayed away from thinking about the impact on terminal bonus rates as was asked for in the question. 4 (i) The model would need to allow for regular premiums rather than just single premiums at the start. It may also need to allow for premiums with different premium frequency, for example, monthly, quarterly, annually. The premium amounts may even be variable or flexible. Modelling terms of more than 10 years, as endowments are likely to have terms of years. Allowing for conversion to paid-up status based on specified assumptions. The payment of renewal commission. Modelling an annual management charge, which may change in the future. Modelling a minimum of the unit fund and the guaranteed sum assured at maturity and death. Therefore will need to consider moving to a stochastic model where the key stochastic variables will be investment returns. There may be other dynamic elements introduced to the new model such as the reserving basis, or the charges could be modelled as varying according to economic conditions. Policyholder actions could be modelled dynamically, such as lower lapses near maturity if it looks likely that the maturity guarantee will bite. Model point generation will need to be restructured to accommodate the above points and possible differences in target market. May need to model duration dependent surrender rates given the change to the surrender penalty. (ii) Initial price: how much does it cost to purchase and implement the new model versus amending the existing model. Page 7

116 Subject ST2 (Life Insurance Specialist Technical) September 2012 Examiners Report Resources: how much effort would be involved in implementing the new model versus amending the existing model, and whether sufficient resources and correctly skilled resources, would be available. Time: how long will each option take to implement and when will the model first be needed and whether the existing bond product could be added to the new model easily. On-going costs: cost of maintaining two different systems, for example lease costs, cost of training up team on new system, ongoing support from the supplying company. Knowledge: existing team will know the current model and will need to be trained on the new system, or a new team created. Complexity: how simple the new model is to develop, maintain and run. Flexibility: how well can the new model cope with changes to product features. The new model may be able to perform stochastic calculations. Data: how easily can the new model link to the data inputs, for example administration system links. Speed of running: may prefer the model with quickest run time. Strategy: long-term plans for the company in terms of products and systems. The reputation of the selling company should be considered and any impact on the company from this. Risks: different risks are run with each approach; development risk if keeping the existing model whereas sourcing a new model introduces counterparty risk. This question was reasonably well answered overall, with candidates finding part (i) easier than part (ii). In part (i), marks were missed by not expanding upon the information provided in the question. For example, making a point related to regular premiums but then not going further by including different premium frequencies, flexible premiums and paid-up options. In part (ii), most candidates mentioned the cost and resourcing impact of both options, but many were less able to think from a practical perspective in order to provide answers covering the wider points. 5 (i) A company would analyse withdrawal experience by: Type of contract Duration in force Sales method/business source/broker Target market/territory Premium size/benefit size Premium frequency Page 8

117 Subject ST2 (Life Insurance Specialist Technical) September 2012 Examiners Report Premium payment method Original contract term Sex Age Type of withdrawal, e.g. income (ii) The calculations involved in the experience analysis should be checked to validate they are correct. Checks should be performed on the data used, for example, spot checks on anomaly values. It should be ensured that deaths and maturities are being excluded and those policies that are being made paid-up but are not withdrawing are also being identified separately. Experience should be analysed by the factors in part (i),i.e. perform a more in depth analysis. Experience was higher than expected but it should be checked what the expectations were. Expectations could have been based on the current valuation and/or pricing assumptions or on the previous year s experience, and so the experience should be checked against each of these. Any comparison should be done at an appropriate level in regard to the subgroups, e.g. product and duration in force groupings. If the company is not comparing like with like, this could be causing the difference. By splitting the analysis by the factors above, it could be determined whether it is only a certain product or a certain sub-group of customers which have caused the higher withdrawal experience. If the analysis is verified as correct, then investigations should be done into the possible cause of the higher withdrawals, for example, a certain IFA may be moving customers. Examples of other possible causes include: Changes in legislation Competitor premium rate / charges changes Changes to premium rates / charges for this company Economic changes Poor customer service Bad publicity for the company There may have been a large number of contracts sold in one particular year that are now reaching a duration which normally experiences withdrawal spikes, for example, the end of a surrender penalty period, and this was not sufficiently allowed for in the expectations. It should similarly be checked whether any guarantees or options are attached to a product that could cause a spike in withdrawals at a certain contract term. Page 9

118 Subject ST2 (Life Insurance Specialist Technical) September 2012 Examiners Report Once the cause is determined it should be considered whether this experience should result in a change to valuation and/or pricing assumptions. This will be strongly influenced by the cause of the withdrawals and in particular, since assumptions should be a reflection of future experience the company needs to consider whether the higher level of withdrawals is expected to continue into the future. If the cause is considered to be a one-off, then it is unlikely that the company will make changes to the future experience assumptions. If the cause cannot be determined then it is also unlikely that the company will want to make large changes to assumptions. If the company discloses an analysis of embedded value, for example, it would be hard to explain to analysts the reason for assumption changes without data to back this up. Similarly, if withdrawal assumptions are used for reserving purposes, then the company needs to avoid making arbitrary changes to the basis. Further data may be required to make this decision, such as industry data or that of competitors. Past practice for the company should also be examined as should any documentation around assumption setting. There may be preset limits which trigger assumption changes. If the investigations flag up a problem area, for example product design, then action should be taken to rectify this. Consideration should be given to performing more regular withdrawal analysis in future. Part (i) was a standard Core Reading list question and most candidates were able to provide sufficient points to score well. In part (ii), some candidates still discussed ways in which the withdrawal experience could be managed despite being instructed not to do so. The majority of answers included reasons why experience could be different to that expected, which picked up marks. Most candidates were able to include checking the data and calculations in their solutions. 6 (i) The formula required is a mixture of a retrospective and prospective formula. The retrospective element is: 1 1 x x+ t x: t xt : xt : xt : D / D ( P 0.95 a S A I e a f A ) The prospective element of the formula is: 0.05 P a + x t Page 10

119 Subject ST2 (Life Insurance Specialist Technical) September 2012 Examiners Report And also need: Where: C P = annual premium S = sum assured I = actual initial expenses e = actual renewal expenses f = death claim expenses C = cost of surrender D x / D x+t, a and x: t experience. 1 x: t A are based on actual mortality and investment return a x + t is based on best estimate future mortality and investment return assumptions. (ii) The policy has been in-force for three years and paid three premiums = = 2,400. 5% of this (120) is taken as profit and therefore needs to be deducted from this amount. 95 is taken as an initial expense 75 is taken for renewal expenses 10 is taken as surrender expenses Investment earnings over the three year period will offset these deductions to some extent. The actual investment return earned has been 4% per annum over the three year period, which is roughly equal to a total return of 8% (the average in force period for premiums paid = 2 years, since they are paid annually in advance), which is approximately 100. The two main reasons for the surrender value being only around 50% of premiums paid are the deduction of future profits and the provision of death benefit cover: The value of future profits (5% of future premiums) is also deducted from the surrender value. This is a material amount due to there being a long outstanding remaining term of the policy (from age 53 to expected death). Allowing for expectation of life and discounting, the multiplier is years. The value of future profits (where x + t = 53 and P = 800) deducted from the surrender value payable is 0.05 P a x + t = = 661. The policy has also provided the policyholder with death cover over the three elapsed years, and the cost of this is also deducted from the surrender value. Page 11

120 Subject ST2 (Life Insurance Specialist Technical) September 2012 Examiners Report This is a material amount due to the high sum assured benefit payable on death. The mortality rate at 50 is , so the approximate cost of death cover over the three years would be ,000 = 525. Therefore, taking into account all of the above elements, the surrender value should be approximately: = 1,015. Although not equal to the quoted figure of 1,200 this is sufficiently close to demonstrate the reasonableness of the figure. (iii) If the experience had been as expected in the pricing basis, then it would be expected that the asset share would run into the sum assured as the policyholder got older. The deduction of the future 5% of premiums would reduce this figure, but this is unlikely to cause the surrender value to become negative as the policyholder is now 85 and the value of future premiums would not be significant. The main reason for the negative surrender value is the actual experience having been worse than expected. Mortality has been as expected, so this is not a contributory factor. Initial expenses are lower than expected and so this is not a contributory factor. Renewal expenses have been 5 per annum more than expected, and over 35 years this will have accumulated to around = 350. Interest has been 4% per annum as opposed to 6% per annum assumed in pricing. This will have had a significant impact on the surrender value. At a high level assuming 50% of the premium is left after expenses and life cover, the impact could be ( ) = 10,000. Death claim and surrender expenses were not priced for and so this would have contributed towards the negative surrender value. It is likely that interest rates have had the biggest impact. (iv) The calculation cannot exceed earned asset shares, in aggregate, over a reasonable time period, and so in this respect it meets this principle. On early surrender, the policyholder is getting back only a fairly low proportion of the premiums paid (e.g. 50% at three years). This may not meet policyholder expectations and so the principle. As identified above, a significant part of the reduction in value would be due to the deduction of future profits. This also may not be consistent with policyholder expectations and so the principle. Page 12

121 Subject ST2 (Life Insurance Specialist Technical) September 2012 Examiners Report There is no data to check how the surrender values compare to those offered by competitors. At 35 years (and probably several years before that), the surrender value would need to be set to zero as the calculation results in a negative value. This does not tend to the sum assured as the policyholder gets older and therefore does not meet PRE. The surrender value is not subject to frequent change, unless dictated by financial conditions and so meets this principle. The approach appears to be complicated, particularly since volatile historic experience either needs to be built into the calculation, or it needs to be smoothed therefore does not meet this principle. It is possible to document this approach and so meets this principle. The principle of no duration discontinuities will not be met if historic movements are not smooth. This was the least well answered question on the paper. Most candidates were able to gain marks on part (i), with most marks being lost by lack of accuracy in providing the formula. In part (ii), many candidates simply calculated the surrender value from the formula, which was not what was requested. The question asked for a reasonableness check, so a more high level calculation with explanation was required and some candidates did make a good attempt at this. Some credit was given for calculating the surrender value where calculated correctly. However, the skills being tested were the ability to identify the key elements of the calculation and use them to demonstrate the reasonableness of the figure. Just inputting the numbers into the formula does not demonstrate such skills, and also may have been unnecessarily time-consuming. Part (iii) was also generally not well answered with most candidates failing to score very highly. Those candidates who were able to pick up some marks noticed the worse experience for both renewal expenses and interest. Part (iv) was reasonably well answered, the most common reason for missing out on marks being not directly answering the question asked and just providing a list of the principles for determining surrender values. Page 13

122 Subject ST2 (Life Insurance Specialist Technical) September 2012 Examiners Report 7 (i) The company will want to obtain evidence about the health of the applicant to assess whether they attain the company s required standard of health. If they do not attain the required standard then an assessment of their state of health relative to that standard will be made. The company will need to obtain medical evidence from the following sources: Questions on the proposal form completed by the applicant Reports from the medical doctors that the applicant has consulted A medical examination carried out on the applicant by a doctor, nurse, paramedic or pharmacist Specialist medical tests on the applicant. The level of medical evidence required will normally increase for higher levels of benefit and higher ages. Other factors that can affect mortality risk will be investigated: Family medical history Smoker status Occupation of applicant Country of residence Possibly also socio-economic factors. Underwriters will interpret the evidence by making use of: Doctors specifically employed by the life insurance company Underwriting manuals prepared by major reinsurance companies. Basic underwriting may be done using specialist underwriting software. For more complex underwriting then experienced professional underwriters will be used. Applicants who reach the required state of health will be offered standard terms. Other applicants may be: Declined, where the company will not accept them on any terms Deferred for a temporary period of time. Offered special terms Sent for further medical tests. Special terms that could be offered can be specified as: An additional premium commensurate with the extra risk An exclusion clause which would exclude payment of claims that arise due to a specified cause or causes. A reduced benefit level. Page 14

123 Subject ST2 (Life Insurance Specialist Technical) September 2012 Examiners Report (ii) Reducing underwriting will reduce underwriting costs and also speed up the application process, which may improve attractiveness of product to distribution channels and may increase volumes sold. Underwriting may not be a barrier to sales for some customers and so volumes would not be affected for these cases. Profit may therefore increase but only if the reduced underwriting costs and impact of higher potential volumes outweigh the potential higher claim costs. If the company has reinsurance then it would need to consult with its reinsurers as the terms offered by the reinsurer are likely to require a certain level of underwriting. If underwriting is reduced then reinsurance terms would be changed and premiums are likely to increase. Alternatively, the reinsurer may refuse to continue to cover the business. The company needs to consider the level of underwriting used by peer companies. If it moved out of line with their practices, then this may expose the company to increased anti-selection, especially if the company ends up with the most relaxed underwriting in the market. Relaxed underwriting and increased anti-selection would mean that the company is likely to end up with worse claims experience. Its standard premiums would therefore have to be increased, which would reduce the attractiveness of the product, and also is likely to make the anti-selection effect worse. The company might find that it has to decline more cases based on the limited underwriting that it does under the proposal, and this could cause poor publicity. A less detailed level of underwriting would reduce the homogenisation of the risks that the company is exposed to. This could lead to higher fluctuation of claims experience and thus the need to hold higher reserves. It would also make product pricing more difficult, for example, parameter estimation is hard as there is no previous experience. There may be options available on the product (for example increasing cover with no evidence of health), reducing initial medical underwriting will also increase the anti-selection risk on these options. The company could consider reduced underwriting in line with a review of the product features, for example it could consider simplified underwriting for policies that are within certain limits (i.e. within specified age ranges, sums assured). Need to consider any regulatory restrictions, although as this is a proposal to reduce underwriting then this is not likely to be an issue. Page 15

124 Subject ST2 (Life Insurance Specialist Technical) September 2012 Examiners Report There may be one-off costs associated with the change, for example changing forms. A tighter claims management process in future may be needed as a result of the changes. Candidates generally answered this question well. Part (i) was standard bookwork and most candidates were able to score well. Despite similar questions being asked in the past, part (ii) was not as well answered with the poorer candidates generally failing to provide a wide enough variety of points to score well. END OF EXAMINERS REPORT Page 16

125 INSTITUTE AND FACULTY OF ACTUARIES EXAMINATION 26 April 2013 (am) Subject ST2 Life 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 seven 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 from the approved list. ST2 A2013 Institute and Faculty of Actuaries

126 1 A life insurance company distributes profits using the contribution method. Value of the contract at the start of the year on the valuation basis 1,000 Value of the contract at the end of the year on the valuation basis 1,200 Gross premium 100 Actual rate of interest earned 5% Valuation basis rate of interest 4% Actual rate of mortality experienced Valuation basis rate of mortality Sum assured 10,000 Actual expenses experienced under the contract 10 Valuation basis expenses 15 Calculate the dividend applicable, showing your workings. [4] 2 A life insurance company has decided to outsource the administration of new and existing policies for a selection of its products. The outsourcing agreement will be in place for ten years and will only cover tasks which are specified in the agreement. The outsourcing company has provided a schedule of initial and renewal costs per policy, which vary depending on the premium frequency of the policy and the number of policies in-force. Describe the factors that the insurance company needs to consider when allowing for the impact of the outsourcing agreement in its future expense assumptions. [6] 3 A life insurance company uses the surrender value respread to reduce future premiums approach for alterations to regular premium contracts, other than where the policyholder is converting their policy to paid-up status. (i) State how this method is applied. [2] (ii) Explain the extent to which this method meets the principles for general alterations. [5] [Total 7] 4 A life insurance company sells a conventional without profits endowment assurance product which is written with a maturity age of 70, but which also allows the policyholder to take a discounted lump sum benefit at either age 60 or 65, these amounts being defined at the start of the contract. The product also offers guaranteed rates for conversion of the lump sum benefit to an immediate annuity at ages 60, 65 and 70. (i) (ii) Discuss the main risks to the company of offering the guaranteed annuity rate option on this product. [8] Describe different methods by which the company could have determined the charge for the option. [9] [Total 17] ST2 A2013 2

127 5 A life insurance company uses a simplistic top-down approach to set its expense assumptions, whereby all expenses are allocated across the products in proportion to the in-force policy count. A new finance director has asked the actuaries and accountants to perform a bottomup review of expenses. Under this new approach, per policy expense assumptions are determined by first considering the actual direct costs of selling and administering policies and then adding an allowance for overhead costs. (i) Suggest reasons why the director has proposed this new approach. [3] (ii) Describe the additional information that the company will require in order to determine expense assumptions using the new approach. [7] The bottom-up review has now been performed and the new per policy expense assumptions have been determined. (iii) Describe the checks that the company could perform on these new assumptions. [6] [Total 16] 6 A life insurance company sells immediate annuities. It is undertaking a mortality experience investigation. (i) List the possible sources of data for this investigation. [4] (ii) Describe the risks to which the company is exposed in relation to these data sources. [8] (iii) Describe the actions that could be taken to minimise these risks. [8] [Total 20] ST2 A PLEASE TURN OVER

128 7 A large multinational proprietary life insurance company is in negotiations with the government of a particular country to write a new government backed scheme to provide child funeral costs. A significant proportion of the country s population is low income, and the infant and child mortality rates are relatively high. The scheme would provide cover for all children of the policyholder, and the premium would be the same irrespective of the number of children covered. The benefits would be to provide all the basic funeral costs on the death of each insured child if this occurs before they reach age 18. The policy would continue after the death of a child if there are other children of the policyholder who are still alive. Underwriting would be on a health questionnaire basis only. The policy would automatically include all new-born children. The government would endorse the insurance company and would allow tax relief on premiums. The insurance company would be the only company allowed to provide this type of insurance. The company does not currently write this type of contract in any other country. (i) (ii) (iii) Describe the factors that the company should consider in determining a suitable design and price for this product. [19] Explain why the company would use a cashflow rather than formula approach to price this product. [8] Discuss how the company would set model points in order to price this product. [3] [Total 30] END OF PAPER ST2 A2013 4

129 INSTITUTE AND FACULTY OF ACTUARIES EXAMINERS REPORT April 2013 examinations Subject ST2 Life Insurance Specialist Technical Introduction The Examiners Report is written by the Principal Examiner with the aim of helping candidates, both those who are sitting the examination for the first time and using past papers as a revision aid and also those who have previously failed the subject. The Examiners are charged by Council with examining the published syllabus. The Examiners have access to the Core Reading, which is designed to interpret the syllabus, and will generally base questions around it but are not required to examine the content of Core Reading specifically or exclusively. For numerical questions the Examiners preferred approach to the solution is reproduced in this report; other valid approaches are given appropriate credit. For essay-style questions, particularly the open-ended questions in the later subjects, the report may contain more points than the Examiners will expect from a solution that scores full marks. The report is written based on the legislative and regulatory context pertaining to the date that the examination was set. Candidates should take into account the possibility that circumstances may have changed if using these reports for revision. D C Bowie Chairman of the Board of Examiners July 2013 Institute and Faculty of Actuaries

130 Subject ST2 (Life Insurance Specialist Technical) April 2013 Examiners Report General comments on Subject ST2 The Examiners Report covers more points than would be expected to get full marks. This is so that alternative approaches to questions by different candidates can be accommodated within the marking scheme. Candidates are expected to show knowledge of the relevant content of the Core Reading, but those who tailor their answer to the specifics mentioned in the question will score more highly than those who answer in a more generic way. Comments on the April 2013 paper As with previous papers, questions that focussed on knowledge of the Core Reading were well answered. In some questions, such as 3(ii) and 7(i), candidates tended only to list factors to consider rather than applying them specifically to the particular situation. Similarly, where questions required candidates to think more widely, such as 6 (ii) and 6 (iii), candidates often did not give comprehensive answers. Candidates should use Examiners Reports to practise applying their knowledge to the situations set. Page 2

131 Subject ST2 (Life Insurance Specialist Technical) April 2013 Examiners Report 1 The formula for the dividend is: (V 0 + P) ( i i) + ( q q )(S V 1 ) + [E(1 + i) E (1 + i )] Dividend = ( ) ( ) + ( ) (10,000 1,200) = = 24.9 This was a generally well answered question though many lost marks through mixing up positives and negatives. A number of candidates failed to deduct the value of the contract at the end of the year from the sum assured. 2 The company needs to make sure that it understands exactly what costs are covered in the agreement and what costs remain with the company, e.g. termination costs are not mentioned as being part of the agreement. In the expense analysis only costs which are covered in the agreement should be replaced with the fixed schedule of costs from the outsourcing agreement. The costs from the outsourcing company should be inflated in line with the terms of the agreement, which may stipulate a fixed rate or increases in line with an index. There may be a modelling issue if the outsourcer expenses inflate at a different rate to the overhead expenses. Need to consider how overheads are impacted by the agreement and how overheads are allocated between products included in the agreement and those that aren t. The insurance company may be able to reduce some of its overhead functions if these are now covered by the outsourcing company, in which case some of its overhead costs would be replaced with the fixed schedule of costs. Need to factor in how expense levels may change over time e.g. due to changes in the numbers of policies in-force (e.g. from persistency) or changes due to new business written. Also need to ensure that models are able to cope with different loadings for policies of different premium frequency Need to consider what happens to costs at the end of the agreement. May need to consider what would happen to expenses if the outsourcing company defaulted or provided poor service. Need to consider loading in additional expenses for the costs of monitoring and managing the outsourcing relationship. The company needs to consider whether it will load into the expense assumptions anything to recover the one-off costs of setting up the outsourcing arrangement, including any potential redundancy costs for existing staff if the company s own administrative functions are reduced. Need to consider whether there are any currency risks if outsourcing charges are denominated in a different currency. This question was well answered by candidates who concentrated on setting of expense assumptions and who considered a variety of points. A number of candidates did not answer the specific question asked, and instead described the wider factors that the company would Page 3

132 Subject ST2 (Life Insurance Specialist Technical) April 2013 Examiners Report need to consider if deciding to outsource rather than those relevant only to setting the expense assumptions; this did not gain marks. 3 (i) The method is: (a) (b) (c) Calculate the premium the company would charge, on the current premium basis, to provide all the policy benefits after the alteration. Calculate a special surrender value, for the existing contract, that makes allowance for the initial expenses included in the above premium.. Spread the special surrender value over the outstanding term, using the above premium basis, and deduct this re-spread surrender value amount from the premium in (a). (ii) The method produces reasonable results when the term is reduced substantially because the value paid on conversion to immediate maturity will run into the normal surrender value. It produces reasonable results when there is a substantial increase in term or in benefits because the method allows for the terms offered on new business. Lapse and re-entry will not be a problem as the premium cannot be greater than that for a new contract. The terms will be affordable by the company provided that the special surrender value does not exceed the earned asset share at the date of the alteration. Similarly, the expected profit should be the same before and after the alteration. However the method can produce unreasonable answers for small changes in outstanding term or sum assured, depending on the surrender value basis and any changes in premium rates since the policy was effected. It also may not be consistent with a conversion to paid-up status on a substantial reduction in premium, with outstanding term unchanged. The costs associated with carrying out the alteration will only be recovered if allowed for explicitly in the surrender value respread. Part (i) was standard bookwork and answered fairly well though a common mistake was to omit the initial expense adjustment. Part (ii) required candidates to recall the principles but then apply them to this method. Weaker candidates only listed the principles, or could recall only the principles relating to setting surrender values or paid-up alterations (which are not relevant here). The stronger candidates correctly identified the relevant principles and discussed how they were or were not met by this method. Page 4

133 Subject ST2 (Life Insurance Specialist Technical) April 2013 Examiners Report 4 (i) The main risk to the company is that at the point of exercise the value of the backing assets will be insufficient to meet the guarantee. The main investment risk is interest rate risk. The precise nature of the underlying investment risk depends on how the company decides to invest to meet the guarantee. The company might decide to hold fixed interest investments which match the maturity lump sum benefits by term. In this case, the risk is from interest rates at the guarantee date being lower than those used within pricing. The company could then also decide to hold derivatives to match the guaranteed annuity options. These would need to be interest rate derivatives such as swaptions. This would reduce the inherent interest rate risk but introduce counterparty risk. In order to minimise the risk of not meeting the cost of the guaranteed annuity benefits due to changes in interest rates, the company might instead decide to treat the policy more as a deferred annuity, i.e. hold fixed interest assets that are of sufficiently long term to back the expected guaranteed annuity payments. Interest rate risk will remain to the extent that precise cashflow matching is not possible. There is now also a risk that more policyholders opt for the lump sum benefit than expected at a time when yields are high. The company may decide to invest in riskier assets in order to maximise the guaranteed return implicit within the contract, for example by holding corporate bonds rather than government bonds. This further increases the risk of not meeting the guaranteed annuity payments, e.g. due to defaults or credit spread widening. There is a risk that the company incorrectly estimates the proportion of policyholders taking up the option and in particular the profile of proportions taking up the option at each age, or a different gender mix if a unisex rate has been adopted. The company is also at risk from improving mortality experience. The company is exposed to anti-selection risk, with a risk that those in better health take the annuity option. Also, the company is at risk from the expenses assumed in the pricing of the guaranteed annuity rate being lower than those experienced, e.g. due to generally higher than anticipated expenses or due to expense inflation being higher than anticipated in the original pricing. If the guaranteed annuity options are in the money then there is a risk of lower withdrawals prior to the exercise date than allowed for in the pricing And similarly if the options are out of the money then there is a risk of higher than expected withdrawals prior to exercise. There may be an additional reputational or mis-selling risk due to policyholders not understanding the option. Page 5

134 Subject ST2 (Life Insurance Specialist Technical) April 2013 Examiners Report There is an operational risk that errors were made when pricing the option. The inclusion of the option may make the contract too expensive, and hence unmarketable, leading to lower than expected new business volumes and problems recovering fixed or development expenses. Alternatively, if the product is very marketable, it may result in high new business volumes which will lead to high new business capital strain (ii) One approach for determining the charge for the guaranteed annuity rate is to use an option pricing approach, i.e. by using the market value of a derivative that closely matches the guarantee or by using a closed form solution. Under the option pricing approach the guaranteed annuity rate corresponds to a call option on the fixed interest bonds that would be necessary to ensure the guarantee was met. Alternatively, a swaption could be used, i.e. an option to swap floating rate returns at the option date for fixed rate returns sufficient to meet the guaranteed annuity option. For either version, the exercise price chosen would be that required to produce the required fixed rate of return. The company would need to determine an estimate for the proportion of policyholders taking the option at each age in order to derive the appropriate mix of terms of option on which to base the pricing. Another alternative for the company would be to use stochastic simulation. A stochastic model is used to simulate the future price of assets. The assumptions underlying the model must correspond to the proposed investment strategy. The most important economic assumption to vary stochastically for this type of option will be interest rates. A large number of simulations are required in order to produce reliable results. The cost of the option for each scenario is any excess of the present value of the guaranteed annuity payments over the lump sum benefit multiplied by the assumed probability of exercise at that age. Assumptions for the mortality and withdrawal experience of the policyholders prior to exercise will also be relevant to the proportions exercising. Withdrawal assumptions may be dynamically linked to economic scenarios. Also need to allow for mortality improvement both pre and post the exercise of the option. The present value of the option can be determined by discounting the simulated cost of exercising the option at a suitable rate. Page 6

135 Subject ST2 (Life Insurance Specialist Technical) April 2013 Examiners Report The company can then charge an additional premium having a present value which reflects the average simulated cost of providing the guarantee, with the potential addition of a margin for prudence. Any additional expenses related to the option would also need to be loaded in. The cost of the option would then need to be allocated in an appropriate way across the policies, allowing for the expected new business profile. In part (i) many candidates covered enough of the relevant sources of risk to score relatively well. However, few candidates discussed in much depth the nature of the investment (interest rate) risk, which depends on the approach taken to matching the guarantee, with only a few candidates mentioning derivatives. Most candidates identified option pricing and stochastic simulation in part (ii), but a disappointing number appeared to have misunderstood this as being a mortality option (and so focused on the conventional and North American methods) rather than a financial/investment option. 5 (i) To produce a more accurate expense allocation at a product level, which has taken into account the actual time spent on each policy/type of expense rather than a uniform allocation. To enable a split between expenses attributed to existing business and new business. To more accurately determine the profitability by product type in order to identify unprofitable or uncompetitive contracts. This could be in order to reduce cross subsidies and reduce company exposure to selling products with low expense loadings and take action as necessary, e.g. repricing or costcutting. To determine a more accurate forecast of future expenses in order that business planning and capital management can be improved and to enable it to reserve more appropriately for future expenses. It may have been suggested by the auditors or by senior management. (ii) As well as more detailed analysis of the expense data, the company will require more detailed breakdown of exposure data e.g. splits of existing business and new business policy counts and premium sizes. For salaries the company will need to perform a detailed review of time spent by the relevant departments on each task, by new, renewal or claim, by product and probably also by premium frequency of the products. It will need the salaries of staff in each department, including loadings for non-salary related costs e.g. pension contributions or any sales related Page 7

136 Subject ST2 (Life Insurance Specialist Technical) April 2013 Examiners Report remuneration costs for sales staff. Timesheets may be required to split time between products and type of expense. Overhead costs will need to be separately identified e.g. HR costs. Rules will be required for allocation of indirect and overhead costs, which may require additional information. For example, property may be allocated in proportion to the floor space that each department uses. Computer costs may be allocated according to computer usage by different departments. Computer costs will need to be amortised and so appropriate amortisation periods will need to be determined for these, e.g. based on expected useful lifetime. Investment costs will need to be identified and apportioned. Information will be required on the specific nature of any one-off costs, such as project costs, so that they can be amortised and allocated appropriately. The expected useful lifetime of any items purchased as one-off capital costs would be needed. Information on any external expenses (e.g. advertising or underwriting costs such as medical tests) will also be required. (iii) Compare the total expenses on old basis and new basis, and compare to budgeted expenses for the same year and check that there are no large differences. If there are any unmodelled products then the modelled expenses will need to be adjusted for these. Compare per policy unit costs under the new approach against the assumptions from the previous year and ensure that any major differences can be explained. Compare the split of total expenses between direct and overheads with that in the previous year assumptions and ensure that any major differences are explainable. Similarly compare the split between initial and renewal expenses with the previous year assumptions. Compare the unit costs per policy for similar products (e.g. two similar single premium products) to ensure that they are similar or that any differences can be explained. Check for any oddities e.g. ratio of regular premium to single premium assumptions or any very large expense assumptions. Ensure that there is no double counting of products or expenses. Compare total expenses to the accounting data to check that all are included. Page 8

137 Subject ST2 (Life Insurance Specialist Technical) April 2013 Examiners Report Ensure that all products have unit costs allocated. Many candidates scored poorly in part (i) with many giving only one relevant reason identified. Part (ii) however was generally better answered, with many identifying and describing adequately the key additional information required. Part (iii) saw a range of marks with those giving thought to sources to compare against scoring well. 6 (i) Sources of data are: Internal policy data for annuities (exposure measure and deaths) Internal policy data for any similar products (e.g. deferred annuities) Reinsurers data Industry data e.g. CMI data and models, actuarial tables National statistics / government data Academic studies Medical journals Consultants data Overseas data (ii) Data risks include in-force or mortality data being inaccurate or incomplete. Information required for grouping could be missing e.g. benefit level or age. The data may be out of date if records have not been maintained, or the data may contain random errors due to manual inputting. Late reported deaths may not be included in the period of investigation, or there may be a lack of notification of the first death on joint life policies. The amount of data may be of insufficient volume, especially once the book is broken down into homogeneous groups and especially at extreme ages (and so individual policies could distort the assumptions for particular groups). Small volumes of data also make it more difficult to analyse (and hence project) trends in longevity. External data may be for a different population and this would result in determining mortality assumptions that are not appropriate for the book of business. This could be due to data being a different socio-economic crosssection of the population, a different geographical area, or due to different underwriting levels adopted (e.g. impaired lives). External data is also likely to be less detailed and more out of date owing to the time taken to collect and publish the information. The data quality is also dependent on the quality of the processes undertaken by each contributor. (iii) The company should reconcile exposure data with that used for previous analysis. To do this data should first be grouped in some sensible way. Page 9

138 Subject ST2 (Life Insurance Specialist Technical) April 2013 Examiners Report Simple checks can be performed by reconciling data at both investigations using business on and business off over the period. This could be done for number of contracts or for the amount of annuity benefits in payment. Data can also be checked against accounts data e.g. annuity benefits paid. Checks could be made for unusual values e.g. zero or very large values or impossible dates of birth or ages. Distribution of data items can be checked to identify outliers or clusters of unusual values. Spot checks can be performed on specific policies. The data extraction process should be checked. The company should also implement automatic checks on input data as well as keep IT systems up to date with well maintained data. Ensure that administration staff are well trained and understand the importance of accurate data. There should be a clear proposal form for the initial data gathering to ensure it is an accurate reflection of the customer s details. Ensure a sufficient volume of data in each population. Check that the populations of any external data being used is consistent with the internal population and, if not, an appropriate adjustment should be applied. Ensure that the most up to date external data is obtained and used and, if necessary, roll forward any lagged data. Check against any national database of deaths to potentially identify any unnotified deaths or first life deaths. The basic bookwork in part (i) was answered well by well-prepared candidates, with many gaining close to full marks. A few candidates concentrated on the individual data fields in the company s own data rather than data sources, as required by the question. The basic points in part (ii) were covered by most, with the stronger candidates expanding on the points, e.g. data at extremes. Part (iii) was generally not so well answered, with some candidates focusing on the wider issues resulting from poor data rather than mitigation actions. Page 10

139 Subject ST2 (Life Insurance Specialist Technical) April 2013 Examiners Report 7 (i) Profitability This is a protection policy and so is likely to be non-linked. The company will need to ensure that the premiums charged will be sufficient to cover the benefits to be provided and the expenses in most foreseeable circumstances and provide an adequate profit margin. The company will need to consider whether it wishes to include sufficient loading in the premiums to recover the product development costs and whether it will require this product to make any contribution to overheads. The company therefore needs to assess the likely volumes of business which could be sold. It will need to consider whether premiums will be reviewable. The company will also need to consider whether it will increase premiums based on answers to the health questionnaire or whether it will exclude individual children. This is unlikely to be popular with the government, but the decision on this would have a material affect on profitability. In determining the price and profitability of the contract, the company will need to ensure that its assumptions reflect appropriately the relatively high mortality rates expected. However policy lapse rates might also be relatively high, as premiums may become unaffordable. Marketability The product design needs to be attractive and marketable. The benefits offered appear to be determined already and it is likely that these are intended to meet a real need at as low a cost as possible. There is therefore little scope in considering innovative design features. The company may consider whether to offer a surrender value, but this is unlikely. The key target market is the poorer section of the population, therefore the company needs to aim to keep the price very low in order for it to be sufficiently attractive to purchase. This may also depend on the distribution method which will be used and how the sales force are remunerated. The product probably needs to be regular premium to ensure affordability and hence need to consider also how premiums will be collected. Competitiveness New products need to be competitive against any similar products available. If the company wins the contract through the negotiations with the government then this will not be an issue as there will be no competitors. If there are other companies in negotiations then the company will need to show value for money. However, financial strength is likely to be the most important factor as the government will not wish to be endorsing a company which could go insolvent. Page 11

140 Subject ST2 (Life Insurance Specialist Technical) April 2013 Examiners Report Financing requirement The company will need to consider any financing requirements and will want to minimise them. This is made more difficult as there is no scope to adjust the benefits; however financing requirements would be lower if the premiums were reviewable. The company will need to check that it has sufficient capital to cover the financing requirements. Risk characteristics The company needs to consider the level of risk associated with the product and its ability to withstand this, which may depend on its level of free assets. The main risks involved are around the child mortality rates, the average number of children that would be insured, the birth rates and the fact that it is an indemnity product covering unknown funeral costs. These costs will also depend on underlying inflation which may be relatively unstable, if this is a developing economy. The company would need to carefully define what is covered (i.e. what is meant by basic funeral costs ) to avoid unexpected payments. It also needs to consider possible aggregation or catastrophe risk (e.g. epidemic, natural disaster), including the concentration of risks in one location. The company will need to consider any correlation between risk factors, such as child mortality rates and number of children in a family. The company would need to include a sufficient margin to allow for the fairly high level of uncertainty, particularly given that it has not written a product like this before and has no existing experience. The government may have data that would be useful. There may also be a high risk of anti-selection, with individuals who are planning to have a large family being more likely to take out the policy. And similarly there may be a high risk of selective lapses, with individuals with more healthy children being more likely to lapse their policies. There is also the potential for fraudulent claims such as claims for uninsured children or from fraudulent distributors not passing on premiums. The company may wish to consider reinsuring some of the risk. This may also enable them to gain technical expertise from the reinsurer with product design, pricing and underwriting. The company would need to consider any investment risk, and the availability of any suitable assets to match liabilities Page 12

141 Subject ST2 (Life Insurance Specialist Technical) April 2013 Examiners Report Onerousness of any guarantees It is unlikely that any further guarantees will be offered in addition to the guaranteed death benefits, since this needs to be a simple low-cost product given the target market. Sensitivity of profit The company needs to consider the sensitivity of profit to variations in future experience. It may be possible to reduce the sensitivity by having reviewable premiums. Extent of cross-subsidies The company needs to consider the extent of any cross-subsidies. There are significant cross-subsidies within the pricing of this product due to there being one premium irrespective of the number of children. It appears that the company has no way of avoiding these cross-subsidies, so it therefore needs to estimate carefully the likely mix of business when pricing the product. It may decide to introduce cross-subsidies with other products, i.e. offering this (at least initially) as a loss leader. Administration systems The company needs to consider the systems requirements of the proposed new product. It is a relatively simple product so this may not be onerous, unless there is a need to allow for reviewable premiums. However, the system may need to allow for a lot of lives insured which may require additional fields. The system will also need to allow for multiple deaths on one policy. Consistency with other products of the company This is unlikely to be an issue given there are unlikely to be any similar products being sold. Regulatory requirements The company should consider any specific regulatory requirements. This should be covered under the negotiations. It could be time-consuming to get a finalised agreed structure. In particular the government will want to ensure that the company cannot increase premiums to an unreasonable level and it will want to ensure that profit margins are not extreme. Particularly given that the target market might be perceived as relatively vulnerable. The company should also consider any tax implications. The company should consider the impacts of either a change in legislation, or change in government. Page 13

142 Subject ST2 (Life Insurance Specialist Technical) April 2013 Examiners Report (ii) The cashflow approach will allow for the complexity of the product i.e. multiple lives insured and multiple projected decrements on the same policy. In particular it will also allow the company to investigate the sensitivity to profit both to the variations in experience (particularly mortality) and the variations in numbers of average children insured. The cashflow approach allows the measurement of the expected return that the providers of capital will receive. A cashflow approach will allow for the projection of both statutory reserves and capital requirements. It will also facilitate allowance for reviewable premiums. The company will wish to project future layers of new business and a cashflow approach will be able to take account of projected layers of new business and can be easily incorporated into a model of the business as a whole. The method can allow more easily for lapses, which are likely given the low level of income of the target market. The company may wish to allow for stochastic decrements or decrements that may vary over time. It is unlikely that stochastic investment returns will be required since this is a protection policy. However, mortality could be projected stochastically and similarly lapses which will impact per policy expenses. The method allows the modelling of interdependencies between variables and the link between the variables and economic conditions. The company will need to model projected birth rates since newborns are automatically insured. This may also need to be varied stochastically as it is a key assumption and may also vary with factors such as the economy. The risk discount rate can take account of the term structure of interest rates. Tax and reinsurance will be easier to allow for. (iii) The company has no previous experience on which to base the model point data and needs to use risk factors to determine model points. The company is therefore likely to discuss this with the government and in particular the likely spread of number of children to be covered. Could use grouping by age of child, sex of child, by region or by parental ages. Need to allow for any rating applied via underwriting, likely volumes of sale and even expected birth rates. The company may need to investigate how the mortality rates vary by age profile. For example it may find that infant mortality rates are higher than for older children. Funeral costs might also vary by age. Page 14

143 Subject ST2 (Life Insurance Specialist Technical) April 2013 Examiners Report It may wish to take this into account in the pricing and so model points will need to allow for all risk factors. Some of the risk factors (e.g. age) may be banded. Note that since there is just one premium for all policies, irrespective of the number of children covered, the premium rate will need to be set across all model points and averaged out. There were many marks on offer for part (i); however many candidates did not include enough detail in their descriptions to be appropriate to the high number of available marks. Listing the factors to be considered( e.g. cross-subsidies) was not enough to score significant marks. Better candidates related each factor to the product e.g. cross-subsidies between smaller and larger families. Few candidates seemed to use the information provided about the negotiations with and endorsement by the government. Part (ii) was generally well answered, with well-prepared candidates gaining good marks by considering a variety of points. In contrast part (iii) was not so well answered with candidates generally not including enough specific detail in their answers that related to the given situation (e.g. not recognising that the company has no data itself on which to base the model points). END OF EXAMINERS REPORT Page 15

144 INSTITUTE AND FACULTY OF ACTUARIES EXAMINATION 4 October 2013 (am) Subject ST2 Life 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 eight 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 from the approved list. ST2 S2013 Institute and Faculty of Actuaries

145 1 (i) Outline the different ways in which life insurance business may be taxed. [2] (ii) Describe the main implications of taxation for life insurance business. [4] [Total 6] 2 (i) State the prospective formula for calculating the surrender value on a without profits whole life contract, defining all notation used. [3] (ii) Explain the impact on the prospective surrender value for such a contract if the basis were updated for: (a) (b) higher mortality rates higher expenses [7] [Total 10] 3 A life insurance company writes a regular premium unit-linked endowment assurance product. The supervisory valuation basis used for this product is prudent and, in addition to the unit reserve, the company holds a positive non-unit reserve. Over a particular year, the actual experience is the same as the valuation basis with the exception that the value of units has increased by more than the rate of unit growth assumed in the valuation basis. The company has decided not to make any changes to the valuation basis at the year end. Explain how this experience will impact the reserves at the end of the year, compared with their expected value on the valuation basis. [9] ST2 S2013 2

146 4 A life insurance company has been experiencing consistently reducing sales of its conventional without profits whole life assurance product over recent years. In order to improve sales, it has been proposed that an option be introduced to the product. The option will be available for new business only. Under this option: The policyholder(s) can increase the level of the sum assured at any time. The total level of increase is limited to be no greater than the original sum assured. No further underwriting is required. The premium charged for the increase will be based on the premium rates which were effective when the original contract was sold, and the age of the policyholder(s) when the option is exercised. (i) Discuss this proposal. [10] (ii) Suggest ways in which the proposal could be improved in order to reduce the risks to the insurance company. [4] [Total 14] 5 A life insurance company has discovered an error during a review of its unit prices. (i) Describe possible errors which may have occurred. [5] (ii) Discuss why it is important to ensure that unit prices are correct. [6] [Total 11] ST2 S PLEASE TURN OVER

147 6 A large life insurance company with a mature in-force portfolio has recently been experiencing higher surrenders on its unit-linked products than observed in previous years. Amongst other actions to address this, the company has decided to implement a retention project. Certain policyholders who contact the company intending to surrender their policy will be offered an alternative policy which better suits their needs, or better terms on their existing policy. Whether a policyholder is offered these options will depend on the value of their policy to the company at the time of surrender. (i) (ii) Describe what the company needs to consider before implementing this project. [10] Describe the possible impact of the retention project on experience assumptions. [2] The company has also performed an exercise to analyse whether the higher surrenders have been experienced by particular sales advisers. This has highlighted that one particular adviser has been encouraging policyholders with high fund values to surrender and move to another insurance company once the policy has reached the end of the surrender penalty period. The adviser gains commission with each such transfer. (iii) Suggest ways in which the company could reduce this activity. [4] [Total 16] 7 (i) Describe the main features of original terms reinsurance. [5] A life insurance company writes individual term assurance business and is considering taking out original terms reinsurance on this business. (ii) Describe the factors that the company should consider when setting the retention limit for this reinsurance. [10] The combined capital required to be held by the reinsurer and the insurance company is less than it would be for the insurance company if it retained all the business. (iii) Explain the possible reasons for this. [4] [Total 19] ST2 S2013 4

148 8 (i) Give possible reasons for the following: (a) (b) (c) A 30 year old male with a young family purchases a 25 year conventional without profits term assurance. A 45 year old female purchases a substantial single premium unitlinked whole life assurance with a guaranteed death benefit equivalent to the single premium. A 65 year old male purchases an index-linked immediate annuity with a guaranteed payment period of five years. [6] (ii) Discuss which distribution channels may have been appropriate for each of these three situations. [9] [Total 15] END OF PAPER ST2 S2013 5

149 INSTITUTE AND FACULTY OF ACTUARIES EXAMINERS REPORT September 2013 examinations Subject ST2 Life Insurance Specialist Technical Introduction The Examiners Report is written by the Principal Examiner with the aim of helping candidates, both those who are sitting the examination for the first time and using past papers as a revision aid and also those who have previously failed the subject. The Examiners are charged by Council with examining the published syllabus. The Examiners have access to the Core Reading, which is designed to interpret the syllabus, and will generally base questions around it but are not required to examine the content of Core Reading specifically or exclusively. For numerical questions the Examiners preferred approach to the solution is reproduced in this report; other valid approaches are given appropriate credit. For essay-style questions, particularly the open-ended questions in the later subjects, the report may contain more points than the Examiners will expect from a solution that scores full marks. The report is written based on the legislative and regulatory context pertaining to the date that the examination was set. Candidates should take into account the possibility that circumstances may have changed if using these reports for revision. D C Bowie Chairman of the Board of Examiners January 2014 Institute and Faculty of Actuaries

150 Subject ST2 (Life Insurance Specialist Technical) Examiners Report, September 2013 General comments on Subject ST2 The Examiners Report covers more points than would be expected to get full marks. This is so that alternative approaches to questions by different candidates can be accommodated within the marking scheme. Candidates are expected to show knowledge of the relevant content of the Core Reading, but those who tailor their answer to the specifics mentioned in the question will score more highly than those who answer in a more generic way. Comments on the September 2013 paper As with previous papers, questions that focussed on knowledge of the Core Reading were well answered. In some questions, candidates tended to only list factors to consider rather than applying them specifically to the particular situation, for example in Q6 (i). Similarly, where questions required candidates to think more widely, candidates should use the number of marks available as a guide the depth of answer required. Some candidates lost marks by not answering the question asked or by not utilising the information in the question or by not building on answers in earlier parts of the question. Candidates should use Examiners Reports to practice applying their knowledge to the situations set. Page 2

151 Subject ST2 (Life Insurance Specialist Technical) Examiners Report, September (i) The most common methods are: A tax on the annual profits of the business, where broadly profits mean the excess of the change in the value of the assets over the change in the value of the liabilities. Tax payable on investment income less some or all of the operating expenses of the company. In addition, there may be a tax on premium income. (ii) Taxation will often reduce the level of profits received by shareholders, increase the cost of life insurance products for policyholders or reduce the value of life insurance benefits received by policyholders. Within a particular country, different types of life insurance business may be taxed on different methods. This can mean that it is lower cost for the consumer if certain forms of benefit can be offered as one type of business rather than another. The taxation treatment of life insurance business may make life insurance more or less attractive as a savings medium especially when compared to contracts offered by other savings institutions, subject to a different fiscal regime. However, tax concessions available to individuals may make the sale of certain types of contract easier or more difficult. This could be in terms of tax relief on premiums or favourable tax treatment of policy proceeds. The ability to avail of favourable taxation treatment may force constraints on policy design, or on assets held. In addition, the fact that taxation can change over time may reduce life insurance companies desire to offer guaranteed products. Changes in the tax regime over time can also represent a risk to the insurance company and the tax regime may influence a decision to sell products to overseas markets. Part (i) was typically very well answered by most candidates. Part (ii) was reasonably well answered. The best scores were achieved by candidates considering a wide range of points. Page 3

152 Subject ST2 (Life Insurance Specialist Technical) Examiners Report, September (i) The prospective formula is: Where: ( m) ( m) x t x t x t x t SA ea fa Ga C S = sum assured x = age of policyholder at date of issue t = duration in-force e = level annual expenses f = death claim expenses G = annual office premium C = costs of surrender a = annuity function payable in advance using expected future investment and mortality assumptions A = assurance function payable continuously using expected future investment and mortality assumptions m = frequency of the premium payments or renewal expenses (ii) (a) Higher mortality than previously assumed will increase the assurance functions and reduce the annuity functions. The value of the sum assured would increase due to the acceleration of the expected death benefit payment, as would the value of death claim expenses. The present value of annual expenses and office premiums would reduce due to the shorter time over which these are expected to be paid. Assuming the surrender value was positive before the basis change, overall, the surrender value would be expected to increase. The level of change would depend upon how long the policy has been in-force. (b) Higher expenses than previously assumed will result in higher future annual expenses and death claim expenses, which will increase the surrender value. It could also mean higher costs of surrender, which would decrease the surrender value. The impact on the surrender value will therefore depend upon the relative size of the present value of the future annual expenses plus the value of claim expenses to the cost of surrender. This in turn will also depend upon how long the policy has been inforce. It is likely that for policies of short to medium duration, the overall impact will be to increase the surrender value. This question was not very well answered. In part (i) most marks were lost by candidates not defining all notation used. Some candidates were able to provide the correct the formula in part (i) but then did not consider the impact on the formula when answering part (ii). Page 4

153 Subject ST2 (Life Insurance Specialist Technical) Examiners Report, September With all else being equal the unit reserve will have increased. The non-unit reserve is the amount required to meet shortfall of future charges relative to expenses and the cost of benefits in excess of the unit fund. The movement in the non-unit reserve will therefore depend on the relationship between these charges and costs. The following impacts will reduce the non-unit reserve: The future value of any charges (e.g. fund management charges, guarantee charges) expressed as a percentage of the fund value will have increased. The cost of any life cover in excess of the unit value will have decreased. However if the cost of life cover is a percentage of the fund then the cost would increase. The cost of any guaranteed minimum maturity value will have reduced. The value of any surrender penalties, if expressed as a percentage of unit fund, will have increased. The following impacts will increase the non-unit reserve: The value of any investment management costs which are expressed a percentage of the fund value will have increased. Similarly any fund based commission is likely to have increased in value. The value of any mortality deductions will have reduced if expressed as a percentage of the sum at risk. The value of any charges or costs that are related to the premium will not change. Nor will the value of any charges which are of fixed amounts, such as policy fees. The ongoing renewal expenses will likely be expressed as a fixed amount per policy and so also will not be affected. On the whole, it is likely that the balance of the above effects will have been beneficial for the non-unit reserves. And the non-unit reserve will be lower than before. For any given policy, the extent of the movement in non-unit reserve will depend on the elapsed duration. For relatively new policies, where the unit fund is small, the movement will be very small. For policies which have built up a reasonable unit fund, the movement will be more significant. It is possible that the non-unit reserve may become negative. Local regulation will specify whether this is permissible or whether it needs to be zeroised. In total, the unit reserve will have increased and the non-unit reserve will have decreased and on balance, it is likely that the total reserve will have increased. This question proved difficult for many candidates. The question asked the impact on the reserves, many candidates discussed the impact on other items. When candidates did Page 5

154 Subject ST2 (Life Insurance Specialist Technical) Examiners Report, September 2013 consider the reserves, answers were generally too high level and did not consider the individual cash flows that are used to determine the non-unit reserve. 4 (i) There are potential benefits to this proposal. Including an option may make the product more attractive to potential customers and it may also be favoured by distributors. Hence it may reverse the decline in sales volumes and should in turn generate more profit for the company. However the effect on sales volumes will depend upon how the overall product including the option compares to those being offered by the company s competitors. Limiting the level of the sum assured increase will cap the increase in the risk borne by the company as will offering it on new business only. No further underwriting is favoured by policyholders so should help with increasing the sales of the updated product and reduces the underwriting expenses of the company. Locking in to the historic premium rates may actually reduce future take up rates if the locked in premium is higher than the premium rate available at the time, for example if there have been mortality improvements since the original rates were set. Using the age of the policyholder(s) at the time of the option take up will help to align the premium charged to the benefit increase. However the proposal increases the risks to the company of selling this product. In particular it increases the risk of anti-selection from the policyholder as those policyholders with lower than average health levels will be more likely to take up the option. There is currently no proposed limit on the age at which the increase can occur, which will substantially increase the risk at older ages and as no further underwriting is undertaken then this further increases the risk as those close to death are more likely to take up the option. Using the premium rates charged at the time of sale locks in those assumptions though if the rates are only based on the premium rates it may be possible to scale them up. As the product is whole life then it may have been many years in the past when these rates were set. Therefore the company will be at risk from worsening mortality experience, worsening expense experience, worsening economic outlook and changing cross-subsidies in the period between setting the original premium rates and option exercise. Financial underwriting would need to be performed at outset to avoid overinsurance, on the assumption that the option is exercised based on maximum sum assured possible post-increase. Initial premium rates will be higher to charge for this option. Introducing the option will increase reserving requirements for the company and margins may need to be high due to lack of existing experience e.g. of option take up rates. Page 6

155 Subject ST2 (Life Insurance Specialist Technical) Examiners Report, September 2013 If reinsurance is currently used for this product, the company will need to consider whether the reinsurer is prepared to cover the option as well. Offering the option only on new business might be deemed by existing policyholders as unfair and there may be lapse and re-entry issues. The company will incur additional costs through developing the new version of the product including system changes, to allow for the option and in particular the complexity of the multiple exercise dates. It may not sell enough additional business to recoup these implementation costs. Alternatively it may sell too much business and so cause an admin strain. It will need to ensure there is sufficient capital to support the new business. The company will also experience additional costs arising from having to monitor the take up and ongoing profitability of the option. The company should also consider whether there are alternative ways in which sales could be improved. (ii) To reduce the risk the company is exposed to from increasing the level of sum assured at any time it could: Restrict the times at which the sum assured can be increased e.g. only allow the sum assured to be increased after 5 years and then every 5 years thereafter Impose a maximum age at which it can be exercised e.g. up to a maximum age of 65. Or restrict the ability to increase the sum assured to certain non-selective events, such as the birth of a child, moving house, getting married or changing jobs. To reduce the risk the company is exposed to from the level of increase in the sum assured it could: Reduce the limit that applies, e.g. 50% increase. The level of increase could be made age dependent such that the level of increase reduces as the age of the policyholder increases. In the case of a joint life policy then this restriction may need to be applied to the older age. To reduce the risk from no underwriting the company could make underwriting a requirement when the option is exercised. Using the original premium rates locks in the assumptions used at sale, so the alternative is to use the premium rates that are in-force at the time the option is exercised though this relies on the company still selling this type of contract throughout the remaining term of these policies. Overall this question was reasonably well answered. In part (i), well prepared candidates scored highly by considering the advantages and dis-advantages of each of the features of the Page 7

156 Subject ST2 (Life Insurance Specialist Technical) Examiners Report, September 2013 option provided in the question. Some candidates were too superficial with their answers. Part (ii) was well answered by those who did well in part (i). 5 (i) An error could have occurred in the unit pricing as the company may be managing a box and may have mis-allocated assets between the unit funds and the box. The systems may have not been updated when switching to/from the appropriation price (offer basis) from/to the expropriation price (bid basis) and this would mean that the wrong number of units may have been allocated or de-allocated making the calculation of the price incorrect. Alternatively the bid may have been used instead of the offer price or appropriation instead of expropriation price. The market value of the assets may have been calculated incorrectly, calculated as at the wrong date or time or input into the systems incorrectly. An incorrect currency rate may have been used when valuing overseas assets. For the appropriation price, the expenses incurred in buying assets may have been estimated incorrectly or for the expropriation price, the expenses incurred on the sale of assets may have been estimated incorrectly. Current assets or current liabilities used in the price may have been incorrect or out-of-date. Similarly accrued income used in the price may have been incorrect or actual income receipts may have been allocated to the wrong funds. Any allowance for accrued tax used in the calculation of the price may have been incorrect e.g. through not allowing correctly for recent changes in tax legislation. If the company applies a bid offer spread or initial charge, it may have been incorrectly applied or the regular management charge may have been applied incorrectly. Any rounding may have been applied incorrectly or inconsistently. There may be an error in the number of units used to calculate the price e.g. taken at the wrong date or input incorrectly. Or finally the price of another fund may have been applied by mistake. (ii) Although there are no statutory or other regulations on the pricing of unit funds and policy documents are usually general the company should ensure that the pricing follows the basic equity principle of unit pricing. This means that the interests of unit holders should not be affected by the creation or cancellation of other units. If errors have occurred in unit prices, then units could have been cancelled or created at the wrong price. If the error is over a prolonged period there are material implications for the charges from the fund. In addition, to the extent that there were transactions on the day(s) for which the unit prices were incorrect, a new unit holder could be allocated fewer units than should have been the case or the amount of benefits received by an exiting unit holder is lower which would not be fair to the unit holders. Page 8

157 Subject ST2 (Life Insurance Specialist Technical) Examiners Report, September 2013 Alternatively, if the transaction is beneficial to the unit holder then it can be difficult to claw back the benefit in these circumstances thus leading to a loss to the insurance company. Correcting transactions retrospectively can be an administrative burden and costly with the possibility that additional compensation may have to be paid to the unit holder. There may also be reputational issues relating to errors, particularly if they occur frequently. This could potentially impact unit holder persistency and new business volumes. Ultimately, the insurance company could be fined by the regulator for poor controls and there could be an impact on financial reporting and reserving. Overall this question was reasonably well answered. As with other questions, candidates scored well by providing a wide range of sources of errors. Candidates that answered part (i) well appeared to generate ideas by considering how unit prices are determined and ways in which these steps may have generated an error. 6 (i) The company will need to perform a cost benefit analysis for the project to ensure that the benefit from the increased level of retention outweighs the cost of implementing and maintaining the project. The cost of implementing the retention plan includes: training the staff for the retention team system changes for monitoring impact setting up dedicated phone line actuarial team time for determining the terms system changes for amending terms on existing policy or for linking two policies together, if required Ongoing costs of the retention team include staff costs and the cost of monitoring of experience of the project. There could be an impact from removing people from other areas of the company to move onto the retention project. The company needs to set rules on when the options will be offered, what different types of alternative policy could be offered, on what terms and how much additional benefit could be offered. They also need to consider how advice will be provided for this. The option should be offered only in cases where there is expected to be a net increase in value/profit. That is, the reduction in value/profit to the company from that policy staying, and getting improved terms, is less than the reduction in value/profit from that policy leaving where value could be measured as embedded value. The former impact, policy staying, is the cost of providing better terms on the new or existing policy and the initial expense incurred in transferring to these new terms/policy. The latter impact, policy leaving, is the Page 9

158 Subject ST2 (Life Insurance Specialist Technical) Examiners Report, September 2013 loss of future profits plus any impact on net assets of the excess of the surrender value over the total of unit and non-unit reserves. The company also needs to consider that there may be lower than average future lapse rates on the amended/new policies as the customers are now more satisfied. There could be the opportunity to cross-sell to the policyholder if they are retained and if they are moving to an alternative policy, then they have saved the additional commission paid to advisers which would have been incurred under a lapse and re-entry. However, they need to be careful not to alienate advisers if the company stops paying renewal commission on existing policies and the impact on existing adviser relationships should be considered. There is a risk that policyholders may surrender their policy just to get enhanced terms. Some policyholders may not feel they are being treated fairly as they are not being offered enhanced terms this would have an impact on the company s reputation and future sales. The company would need to consider any regulation around this including TCF and ability to provide advice. It may actually be beneficial to the company for some policies to leave as they are loss making. The company may choose to target low duration policies under which initial expenses have not yet been recouped. They need to consider how to monitor benefits, targets etc. and whether the offer will vary by sales channel. Thought should be given to whether competitors have implemented similar retention plans and how successful they have been. (ii) Future withdrawal rates should be lower but they need to consider when the benefits are expected to be seen and for how long the retention project is expected to last. Paid-up rates may also be reduced if such policies are also targeted and lower withdrawal rates may mean that per policy expenses can be reduced. Mortality assumptions could also be lower for example, due to large policies being targeted to retain. The expenses for the retention project could increase the expense assumptions. (iii) The company could discuss the issue with the adviser on the basis that simply highlighting that the company is aware may deter the activity. They may investigate whether the adviser is giving bad advice to policyholders and highlight to ombudsman or regulator if they suspect they are. Extending the surrender penalty periods could discourage early churning or introduce loyalty bonus payments at longer terms, to give an incentive for the policyholder to stay. They should ensure that charges are lower than those of competitors, particularly at longer terms. Paying renewal commission rather than initial commission would be an option, this could be premium or fund based. Page 10

159 Subject ST2 (Life Insurance Specialist Technical) Examiners Report, September 2013 The company could extend commission clawback to beyond the surrender penalty period, if this is not already the case. They should ensure the policyholders that are with this adviser are coming through the retention project but could stop sales from this adviser. Overall this question was not well answered. In part (i) many candidates provided a standard list of reasons why surrenders would be high rather than answering the question. Many candidates failed to discuss the value of the policy or to consider the trade-off between retaining the profit on the policy and the cost of retention. Part (ii) was reasonably well answered and most candidates were able to provide a spread of actions the company could take to deter the adviser, in part (iii). 7 (i) This is also known as coinsurance. All aspects of the contract are shared between the cedant and reinsurer. There are two methods to calculate the premiums: 1. The cedant supplies premium rates to reinsurer, these are referred to as retail rates. The reinsurer then calculates the reinsurance commission it is prepared to pay the cedant for the business 2. The reinsurer provides premium rates to the cedant. The cedant then loads for costs and profits to get the retail rates. The amount to be reinsured can be specified as: Individual Surplus where the reinsured amount is the excess of benefit over the retention limit on each individual policy. Quota Share where a specified percentage of each policy is reinsured. It is possible to combine individual surplus and quota share. (ii) The purpose of taking out the reinsurance will affect the desired retention limit. For example, if it is intended to gain technical assistance a low retention percentage would be used or if it is for the reduction of parameter risk the retention limit may be higher. If it is to protect against individual large claims the retention limit may be even higher. The concentration of risk by factors will play a part, e.g. by geographical area. The size of the book of business being considered will also be a factor as this will influence the likely variations in claims. All else being equal, a larger book of business will allow a higher retention (and vice versa). The experience level of the company will be relevant, e.g. a new company or product will have limited experience so may use a lower retention limit. Page 11

160 Subject ST2 (Life Insurance Specialist Technical) Examiners Report, September 2013 The average benefit level and the expected distribution of the benefit will also be taken into account and whether there are any options to increase sums assured. The company s risk appetite will affect the desired limit, this will be dictated by the company s risk policy and will reflect shareholders requirements, e.g. a lower risk appetite will result in a lower retention limit The levels of free assets the company has matter, as lower free assets would imply a lower retention limit. The level of financing required for new business would affect the retention limit if required for this purpose. Also the importance attached to the stability of the free asset ratio. Retention limits available in the market and the effect of the retention limit on the reinsurance terms or price will be considered as will the effect on regulatory capital of the level of retention limit. Consider the potential reduction in profits and the marginal cost of increasing the retention limit compared with capital and other benefits or compared with the cost of financing an appropriate mortality fluctuation reserve. This will be particularly important with the product being term assurance business, which is very price sensitive in the market. The underwriting policy of the company will be a factor, particularly its level of familiarity with underwriting this type of product. The level of retention on any existing arrangements the company has needs to be considered. The existence of any profit sharing arrangements also play a part as sharing profit will allow a lower retention limit for the same premium as would be the case if there was no profit sharing. (iii) The reinsurer may hold a more diversified book of business, and hence through diversification benefits can hold lower capital requirements than the company could. This could be within the product or across products or across territories. The reinsurer may use a different reserving basis to the company, e.g. the mortality basis may be lighter though still within a range acceptable to the regulator. This could be due to the reinsurer having more experience and so allowing for less prudence when setting assumptions. The reinsurer may be able to utilise having a different tax basis as a benefit in the capital requirements. The reinsurer may be subject to a different regulatory or tax regime, with lower regulatory capital requirements. This may be because they are based overseas. Part (i) was standard bookwork and answered well. Part (ii) was reasonably well answered, candidates lost marks by not providing a wide enough range of points for the level of marks Page 12

161 Subject ST2 (Life Insurance Specialist Technical) Examiners Report, September 2013 that were on offer. In part (iii), most candidates that provided an answer mentioned the diversification benefit and having different regulatory/tax regimes. 8 (i) (a) Term Assurance He may want to provide protection for his family in the event of his death and wants the cheapest option, rather than a whole life or endowment assurance. 25 years: he wants to provide cover for long enough for the children to go through higher education and establish themselves financially or it could be linked to a 25 year mortgage or repayment of a loan. Conventional without profits provides a guaranteed benefit and hence certainty, which will be reassuring. (b) Whole Life She may want to save for later life and has reached a point where she has a lump sum to invest. She wants to protect the investment in the event of her death. Given it is a substantial sum it may be required to cover potential liabilities on death e.g. inheritance tax. It is relatively attractive compared to other investment vehicles, for example due to tax. Invested in unit-linked in order to gain exposure to different asset types and maximise the potential for returns. She is likely to be aiming to stay invested for long enough that volatilities in unit fund values are not a concern. The customer is affluent and so is prepared to take the unit-linked risks. (c) Annuity He probably wants to provide a regular income to cover living costs which is guaranteed for life, therefore reducing the worry of running out of capital in later old age. He wants index-linked to ensure that the income keeps paces with living costs and protects against high levels of inflation. He may have to buy an annuity from a maturing pension policy as a result of local regulations and may want to secure at least a five year income in order to protect capital and hence added a guaranteed period. (ii) (a) Term Assurance This is a relatively simple product so can be purchased from most distribution channels. He may already have relationship with an insurance intermediary so could use them. An insurance intermediary would also provide the best deal across the whole market and may be the most appropriate if there are any potential underwriting issues, e.g. potential ratings. Page 13

162 Subject ST2 (Life Insurance Specialist Technical) Examiners Report, September 2013 If it is linked to a mortgage/loan, then he may purchase it through the lender who could be tied to a life insurance company. If they already have contact with an insurance company then he could use the direct sales force. They could use direct sales methods e.g. through internet or respond to other advertisements or mailshots assuming simple underwriting is appropriate. (b) Whole Life This is a more complex product and with a substantial sum invested so is likely to want advice on the best product, charges and investment options and may need tax advice. She is likely to use an insurance intermediary, especially if they have a relationship already. Tied agents may be used, but this would limit the choice of products and/or unit-linked funds. Own salesforce may be used if the lump sum is from a maturing policy, e.g. an endowment. She is unlikely to use direct forms of selling, e.g. internet/mailshots. (c) Annuity There is likely to be an investment of a large lump sum. If it is from a maturing pension policy, he could just reinvest with the same insurance company, in which case there is likely to be a simple application form. He could use insurance intermediaries to research the market for the best annuity rates. Intermediaries are likely to be involved if it is for an impaired life annuity. He could research via the internet but companies may not offer certain options via internet, e.g. guaranteed period, index linking. He is unlikely to use other forms of direct sales, e.g. mailshots, advertising. He could use tied agents or own salesforce if they already have that relationship. This question was well answered. In part (i) most candidates were able to provide reasons why the specified products would be purchased. Similarly most candidates were able to specify the appropriate distribution channel(s) and provide justification. Some candidates lost marks by failing to utilise their answer in part (i) to help in answering part (ii). END OF EXAMINERS REPORT Page 14

163 INSTITUTE AND FACULTY OF ACTUARIES EXAMINATION 29 April 2014 (pm) Subject ST2 Life 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 five questions, beginning your answer to each question on a new page. 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 from the approved list. ST2 A2014 Institute and Faculty of Actuaries

164 1 (i) State the basic equity principle of unit pricing for an internal fund. [1] A growing life insurance company is actively selling unit-linked products. (ii) Explain how such a company would calculate its unit prices. [7] (iii) Describe how the company should react if there was a large outflow of money from a particular unit fund. [2] [Total 10] 2 (i) Describe the components of embedded value, and how its calculation may vary for different types of life insurance. [8] A proprietary life insurance company has written conventional with profits business within its With Profits Fund, and has written unit-linked and conventional without profits business within its Non Profit Fund. All profits from the Non Profit Fund are attributed to the shareholder. Following each annual supervisory valuation, bonuses are declared on the with profits business and the cost of those bonuses is added to the supervisory reserves. An annual transfer then takes place from the With Profits Fund to the Non Profit Fund that is equal to 10% of the supervisory cost of the bonuses declared. A summary of the annual valuation results is shown below. The assets are shown before any transfers between the Funds have taken place. Supervisory Reserves (excluding Cost of Bonus) Conventional With Profits 40,000 Conventional Without Profits 10,000 Unit-Linked business unit reserves 30,000 Unit-Linked business non-unit reserves 5,000 Cost of Bonus 500 Value of Assets With Profits Fund 45,000 Non Profit Fund 50,000 Present value of future shareholder profits (after tax) Conventional With Profits 1,000 Conventional Without Profits 5,000 Unit-Linked business 15,000 The present value of future shareholder profits for the With Profits Fund allows for an assumed level of bonus that will gradually distribute the surplus assets in that fund over the lifetime of the policies, but does not include the shareholder transfer due at the valuation date. The regulatory solvency capital requirement is calculated as 4% of all conventional and non-unit reserves plus 1% of unit reserves. ST2 A2014 2

165 The market in which the company operates uses two standard metrics when considering life insurance companies: the solvency ratio, which is calculated as the supervisory surplus (i.e. net assets) divided by the solvency capital requirement and is presented as a percentage; and the embedded value. (ii) Calculate the two standard metrics as at the valuation date, showing your workings. [6] The Chief Financial Officer has suggested that the level of prudence in the supervisory reserves could be reduced, given that the solvency requirement means that the company already holds an additional percentage of reserves. (iii) Discuss this suggestion. [5] [Total 19] 3 A proprietary life insurance company sells a conventional without profits endowment assurance product. When a policy is surrendered, the company pays a surrender value equal to the sum of the premiums paid up to the surrender date. (i) Explain the extent to which this approach satisfies the general principles for surrender values. [13] The company also sells a conventional without profits term assurance product. A policyholder has held one of these term assurance policies for a number of years and has now requested that it be altered to a conventional without profits endowment assurance policy for the same outstanding term and the same sum assured. The company has no existing methodology in place for such an alteration. (ii) Discuss how the company might determine the terms that it could offer for this alteration. [9] [Total 22] ST2 A PLEASE TURN OVER

166 4 (i) State the principles of investment for a life insurance company. [2] (ii) Describe, with reasons, an appropriate asset mix for each of the following types of liability: Conventional with profits endowment assurance product, under which profits are distributed using the additions to benefits method. Conventional level immediate annuity product for seriously impaired lives. [15] Extracts from the balance sheets for two life insurance companies A and B are shown in the table below: Liabilities Company A Company B With profits liabilities based on net premium valuation 20,000 20,000 Solvency capital requirements 5,000 5,000 Free assets 23,000 2,000 Total liabilities 48,000 27,000 Assets 48,000 27,000 Other information Asset shares 30,000 18,000 (iii) Explain how the investment strategy may differ between the two companies. [6] [Total 23] 5 In a particular country, the market for life insurance products has been contracting over the last few years. The government of the country would like to reverse this trend by encouraging the purchase and sale of life insurance products. Discuss the potential actions that the government could take in order to do this, including how effective they might be. [26] END OF PAPER ST2 A2014 4

167 INSTITUTE AND FACULTY OF ACTUARIES EXAMINERS REPORT April 2014 examinations Subject ST2 Life Insurance Specialist Technical Introduction The Examiners Report is written by the Principal Examiner with the aim of helping candidates, both those who are sitting the examination for the first time and using past papers as a revision aid and also those who have previously failed the subject. The Examiners are charged by Council with examining the published syllabus. The Examiners have access to the Core Reading, which is designed to interpret the syllabus, and will generally base questions around it but are not required to examine the content of Core Reading specifically or exclusively. For numerical questions the Examiners preferred approach to the solution is reproduced in this report; other valid approaches are given appropriate credit. For essay-style questions, particularly the open-ended questions in the later subjects, the report may contain more points than the Examiners will expect from a solution that scores full marks. The report is written based on the legislative and regulatory context pertaining to the date that the examination was set. Candidates should take into account the possibility that circumstances may have changed if using these reports for revision. D C Bowie Chairman of the Board of Examiners July 2014 Institute and Faculty of Actuaries

168 Subject ST2 (Life Insurance Specialist Technical) April 2014 Examiners Report General comments on Subject ST2 The Examiners Report covers more points than would be expected to get full marks. This is so that alternative approaches to questions by different candidates can be accommodated within the marking scheme. Candidates are expected to show knowledge of the relevant content of the Core Reading, but those who tailor their answer to the specifics mentioned in the question will score more highly than those who answer in a more generic way. Comments on the April 2014 paper As with previous papers, questions that focussed on knowledge of the Core Reading were well answered. In some questions, candidates tended to only list factors to consider rather than applying them specifically to the particular situation, for example question 3. Similarly, where questions required candidates to think more widely, candidates often did not develop responses to the required depth, e.g. question 5. Stronger candidates considered the specifics of the question and used these in their answers. Candidates should use Examiners Reports to practice applying their knowledge to the situations set. Page 2

169 Subject ST2 (Life Insurance Specialist Technical) April 2014 Examiners Report 1 (i) The basic equity principle of unit pricing for an internal fund is that the interests of unitholders not involved in a unit transaction should be unaffected by that transaction. (ii) The company would calculate the unit prices based on the appropriation price. Since the company is growing and is actively selling unit-linked products, it would price on an offer basis. The appropriation price is the price at which the company will create a unit, i.e. the amount of money the company should put into the fund in respect of each unit it creates in order to preserve the interests of the existing unitholders. The appropriation price is calculated as: the market offer price value of the assets held by the fund, plus the expenses incurred in the purchase, plus any stamp or other duty payable in respect of such a purchase, plus the value of any current assets e.g. cash on deposit or investments sold but not yet settled, less the value of any current liabilities e.g. loans to the fund or investments bought but not yet settled, plus any accrued income, e.g. interest income from fixed interest securities and deposits, net of any outgo e.g. fund charges less any allowance for accrued tax. This gives the net asset value of the fund on an offer basis. When divided by the number of units existing at the valuation date (before any new units are created) this gives the appropriation price. The appropriation price would then be used to determine the offer and bid prices. The offer price would be determined as the appropriation price plus an initial charge (e.g. bid/offer spread). The bid price would be determined as the appropriation price. The offer and bid prices would then be rounded to a pre-defined number of decimal places. For example, rounding up would be in the company s favour or down would be in the policyholders favour. (iii) Given that it is a significant outflow of money the company would look to switch the pricing to a bid basis i.e. pricing on the expropriation basis. When determining the expropriation price the investments of the fund are valued on a market bid basis rather than a market offer basis and expenses Page 3

170 Subject ST2 (Life Insurance Specialist Technical) April 2014 Examiners Report incurred on the sale of the assets would be deducted rather than adding in the purchase expenses. If the large outflow is a one-off or temporary situation, the company would then switch back to an offer basis. The management box could be used to absorb the effects of a one-off outflow. May consider the viability of the fund, dependent on the reason for the outflow and if outflows are expected to continue. Part (i) was answered well by most candidates. In part (ii) stronger candidates focussed on the specifics of the question and stated that the company would be using an appropriation basis rather than just describing both bases. Marks were low in part (iii) where candidates focussed on finding the cause of the price drop rather than actions or did not relate this to the question of pricing and considered wider business implications. 2 (i) The embedded value (EV) is the present value of future shareholder profits in respect of the existing business of a company including the release of net assets. Only the shareholder owned share of net assets is included in the value. Net assets are the excess of assets held over those required to meet liabilities. The net assets may be at market value or may be discounted to reflect lock in, for example if held to cover solvency capital requirements. The present value of shareholder profits arising on existing business is calculated as follows: For conventional without profits, it is the present value of future premiums plus investment income less claims and expenses plus the release of solvency reserves. For unit-linked, it is the present value of future charges including surrender penalties less expenses and benefits in excess of the unit fund plus investment income earned on and the release of any non-unit reserves. For conventional with profits, it is the present value of future shareholder transfers e.g. as generated by bonus declaration. Note that this could allow for the gradual distribution of the estate, if this is not included in the value of the shareholder share of net assets component. For without profits business EV is effectively the release of margins within supervisory reserves, relative to assumptions used in embedded value. Page 4

171 Subject ST2 (Life Insurance Specialist Technical) April 2014 Examiners Report The reserves used in the calculation of net assets should be consistent with those used in determining the present value of future profits. Tax will be allowed for as appropriate and assumptions used are likely to be prudent for reserves and best estimate for VIF. (ii) Solvency Ratio: Assets in With Profits Fund plus Assets in Non Profit Fund = 95,000 Liabilities: CWP + CNP + UL + COB 40, , , ,000 = 85,000 (excluding COB) = 85,500 (including COB) Solvency Requirement: 4% of all non-linked liabilities + 1% of linked liabilities 4% (40, , ,000) ,000 = 2,500 (excl COB) + 4% 500 = 2,520 (including COB) Solvency Ratio = (95,000 85,500)/2,520 = 377% Embedded Value: Take shareholder assets only = 50,000 Shareholder share of net assets: 50,000 10,000 35,000 = 5,000 The assets in the With Profits Fund are not included, given they are effectively included in the present value of shareholder transfers from that fund. Add on COB transfer of % = 50 And total PV of future profits = 21,000 Embedded Value = ,000 = 26,050 (iii) The solvency capital requirement can be seen as providing an additional level of protection for policyholders. Need to ensure that all requirements of the local supervisory authority are met and consider any local professional guidance. The CFO is correct that when considering the adequacy of the reserves, it is important to consider this within the overall context of solvency capital requirements. It may be possible, in some jurisdictions, to hold best estimate base reserves with an additional risk margin and risk-based solvency requirements. However, in this case the solvency capital requirement does not necessarily adequately reflect the risks borne by the company for each of the blocks of Page 5

172 Subject ST2 (Life Insurance Specialist Technical) April 2014 Examiners Report business. The 1% of unit reserves will move in line with market movements which would not suitably reflect the risks to the company associated with this block of business e.g. low capital requirements when low unit fund giving rise to a low level of expected future charges. The 4% of non-linked liabilities implies the risks for with profits business are similar to those of the without profits business. This is unlikely to be the case, since with profits experience is largely borne by policyholders. Hence could reconsider the prudence of reserves, but need to ensure that the principles of setting them are still met. Under this method if the reserves fall then the capital requirements also fall. The company would want to avoid arbitrary changes in basis and hence would need to ensure that any changes are justified based on analysis. The reserves held could already be at the minimum prescribed level required by the regulator and hence could not be reduced further. The company is healthy so no driver to reduce prudence though arguably figures in (ii) show prudence could be reduced. Reducing prudence would allow more investment freedom. In part (i) the stronger candidates expanded the definition of shareholder profits to describe this across the different profit types where weaker candidates either did not expand their answers or focussed on specific products, e.g. term assurance. The most common mistakes in part (ii) were to miss out the cost of bonus elements or to use all net assets rather than only those owned by the shareholder. For part (iii) most candidates picked up some marks but few commented on the inadequacy of the solvency capital to reflect the risks borne by the company. 3 (i) The surrender value paid should take into account the policyholders reasonable expectations. This is met if this has been clearly described in marketing literature provided to the policyholder at the point of sale. The surrender value should not exceed the earned asset shares, in aggregate, over a reasonable time period. This surrender value approach will over pay on surrender early in the policy term and under pay towards the later part of the policy term. This gives a lapse and re-entry risk at early durations. Whether it meets the principle in aggregate will depend on sales volumes over time and lapse rates over time. But it would be difficult for the company to manage actively. Particularly since such an approach would be more likely to encourage early surrenders and discourage late surrenders. The surrender values should produce a fair contribution to company profit. This objective may be difficult to meet, since (as per the arguments above) profits made may be excessive for surrenders at later periods and losses may be made on surrenders at early periods. Page 6

173 Subject ST2 (Life Insurance Specialist Technical) April 2014 Examiners Report Surrender values should treat both surrendering and continuing policyholder equitably. As this is a without profits contract, the terms offered to surrendering policyholders do not directly affect the continuing policyholders. However the price of the product might be greater than it would otherwise have been, to allow for the high cost of early surrenders. It is also hard to see that the surrender value close to maturity is equitable relative to the benefits received by policyholders continuing to maturity. At early durations, surrender values should not appear too low compared to premiums paid taking into account any projections given at the new business stage. The method meets this principle well (subject to appropriate information being provided at the new business stage as mentioned earlier). Surrender values should take into account those offered by competitors and auction values, where available. It may be that this is typical for the market and so is consistent with competitors otherwise, it will not compare well. Auction values tend to be based on a prospective valuation, so this basis will not compare favourably at later durations. At later durations, surrender values should be consistent with projected maturity values. It is very unlikely that this will be the case, so this principle is not met. The maturity value is a contractual amount and is unlikely to have a direct relationship with the total premiums paid. Due to the anticipation of investment earnings over the period of the policy, the maturity value would normally be expected to be materially higher than the total premiums paid in. Surrender values should not be subject to significant discontinuities by duration. The surrender value basis will meet this objective. Surrender values should not be subject to frequent change, unless dictated by financial conditions. The surrender value basis will meet this objective. Surrender values should not be excessively complicated to calculate. The surrender value basis will meet this objective. The surrender values should be capable of being documented clearly. The surrender value basis will meet this objective. Whilst the basis meets many of the principles, overall it is unlikely to be satisfactory in the market as a result of those which it does not meet. (ii) The surrender value respread method could be used. PUP respreads method gives the same as effect as SV respreads for a term assurance. The surrender value of the original policy at the alteration date is used to reduce the premium that would otherwise be paid for the new policy. A special surrender value, of the existing contract, is calculated that makes allowance for the initial expenses. The premium is reduced by spreading the special surrender value over the outstanding term but conventional term assurance has no surrender Page 7

174 Subject ST2 (Life Insurance Specialist Technical) April 2014 Examiners Report value. So the resulting premium would merely be the same premium as for a new without profits endowment. The policyholder has received no benefit from the value of the existing policy under these alteration terms. He has received death benefit protection from inception to the alteration date but this has not been used so its value may not have been appreciated. The policyholder may not feel that it is acceptable to receive no credit in respect of the premiums already paid. However, the company may feel that the request goes beyond an alteration. And so does not feel compelled to pass on any value from the existing policy. But there will be some accrued value as the company has received a premium designed to be level over the term, whilst being on risk when the mortality was lightest. The equation of policy values method could be used. This would equate the value of the contract before alteration with the value after alteration. A prospective valuation should be used for the post-alteration value but the pre-alteration value could be done using either a retrospective or prospective method. It would therefore allow some value from the existing policy to be used to offset the premium that would otherwise be charged for a new without profits endowment assurance. The choice of method and basis used to value the policy before alteration determines the profit released at the alteration date. The choice of method and basis used to value the policy after alteration determines the profit expected after the alteration date. The company might use its current premium basis to value the policy after alteration. To value the policy before alteration it might use a basis that retains, for the company, the profit accrued to date. It may not be appropriate to take both the expected profit from the endowment assurance and the total expected profit from the term assurance. The accumulation of premium arrears/surplus method could be used. The premium is compared with that which would have been paid had the policy been in its altered form from the outset with the accumulated difference being spread forward as a premium adjustment. This might be an appropriate method as the benefits of an endowment assurance from the date of commencement to the date of the alteration are the same as for the existing term assurance. However, the simplest method might be to recognise that the only difference in the benefits after the alteration date is the addition of the maturity benefit. The additional premium required would therefore be the premium required from the alteration date to provide only the maturity benefit, i.e. the premium payable for a pure endowment. This would probably be on the pricing basis for the endowment assurance product. Page 8

175 Subject ST2 (Life Insurance Specialist Technical) April 2014 Examiners Report The company might also allow for the costs of making the alteration in any of the methods shown Generally good marks were scored in part (i) with highest marks where candidates logically outlined each of the principles and whether the method met these or not. Candidates struggled with part (ii) and in particular few noted that a term assurance would not generally have a surrender value. Many also got distracted from discussing alteration methods and instead concentrated on the principles again and very few discussed the methods in sufficient depth. 4 (i) In order to minimise risk, a company should select investments that are appropriate to the nature, term and currency of the liabilities. The investments should also be selected so as to maximise the overall return on the assets, where overall return includes both investment income and capital gains. The extent to which the appropriate investments referred to above may be departed from in order to maximise the overall return will depend, inter alia, on the extent of the company s free assets and the company s appetite for risk. Alternatively: The company should invest so as to maximise the overall return on the assets, subject to the risk being taken on being within the financial resources available to it. (ii) Conventional with profits endowment assurance: The liability has a guarantee in money terms equal to sum assured plus reversionary bonuses declared to date. There is also a discretionary part equivalent to future bonuses that have not yet been declared or added particularly terminal bonus. To match the guaranteed benefits, the starting point is likely to be fixed interest securities of appropriate term such that the flow of asset proceeds is best matched to the liability outflows may be a mix of government and corporate bonds. To back the discretionary benefits, likely to be invested in real assets in order to seek higher potential returns and thus to generate competitive bonus levels such as equities and properties. The mix overall depends on policyholder expectations, what has been described in literature, past practice, asset mix held by competitors, the relationship between asset shares and guarantees and the extent of any free estate. Page 9

176 Subject ST2 (Life Insurance Specialist Technical) April 2014 Examiners Report The higher the free estate, the more freedom the company has to mismatch the guarantees and invest more in real assets. There may also have some derivatives to hedge the guarantees. Consideration of PRE and/or reversionary/terminal bonus mix. Level immediate annuities for impaired lives: The liability is guaranteed in money terms with the term depending on degree of impairment, but likely to be significantly shorter that for nonimpaired annuities. Regular income is required from assets to pay annuity outgo. Fixed interest securities are likely the best match. A mix of government bonds and corporate bonds likely. Corporate bonds give higher yields which may be important if annuity pricing is competitive or if government bonds are in short supply. But corporate bonds are less secure, with a higher chance of default. The proportion of corporate bonds is relative to free asset levels Should aim to match cash flows by term so the fixed interest bonds are likely to be fairly short term. Expenses may be matched by index-linked bonds. Both Possibly need cash for liquidity. For optimal matching, all investments held should be in the same currency as the liabilities. Consider diversification of investments and any regulation restrictions. (iii) Company A has a free asset ratio of (23,000/48,000) = 48% Company B has a free asset ratio of (2,000/27,000) = 7% The existence of a significant level of free assets in Company A means that it can move further away from the ideal matched position in order to invest in riskier assets that could yield higher overall returns. Page 10

177 Subject ST2 (Life Insurance Specialist Technical) April 2014 Examiners Report Company B has very low free assets and so will need to match its liabilities more closely. Company A is therefore likely to invest a higher proportion of its assets in riskier or real assets than company B e.g. equity, property, overseas investments or corporate bonds. They also have wider scope for diversification. However Company B s policyholders may still have an expectation that their assets will be invested in some equities. Company B may therefore have some derivatives to aim to hedge the guarantees (e.g. protect against equity falls). Company B s guarantees are likely to be heavily in the money, as shown by the relationship between the asset shares and the reserves. Therefore this could mean that Company B policyholders are unlikely to get any terminal bonus unless markets did extremely well. This again may mean that Company B is invested more in fixed interest with perhaps some derivatives which pay off if equities do well. Company A s asset shares are well above the reserves and so this means even more flexibility and this could mean even more scope to invest in real assets. Given the high level of guarantees, Company B may also be cashflow matching, which would mean careful monitoring of the asset and liability movements. In addition, Company B may therefore be holding the fixed interest assets to maturity whereas Company A may have a more active trading strategy for its fixed interest portfolio. The standard bookwork in part (i) was well answered. In part (ii) candidates were often able to discuss the key requirements of an investment strategy (in terms of matching to term, nature and currency but many failed to expand these concepts as they apply to the products contained within the question. Some candidates spent considerable time discussing the different bonus distribution methods which scored no marks. Only the stronger candidates calculated the free asset ratios in part (iii) and while most candidates realised that high free assets means potential investment freedom, very few understood the relationship between asset shares and the net premium reserve. Page 11

178 Subject ST2 (Life Insurance Specialist Technical) April 2014 Examiners Report 5 The actions that could be effective will depend on what is causing the decline in sales. It could be either driven by lack of products/insurers selling products, a low customer propensity to buy or from a general reduced level of wealth, e.g. due to recession. The government could relax any existing restrictions including: Contract type Any restrictions on types of contracts that can be sold could be lifted which could lead to new products coming to the market or more innovation in the market. Though this is only likely to increase sales if a new product meets a customer need that is not addressed by the existing products. Rating factors Rating factors that are allowed to be used in pricing may be restricted and these restrictions could be relaxed. This could allow insurers to have differential pricing for more subsets of customers. This could lead to increased sales if it now allows an insurer to offer a product which they previously were not comfortable about pricing on the restricted rating factors though this will only happen if the rates they offer are then competitive. Alternatively it may mean that, for pricing purposes, insurers now split a group that was previously priced together into smaller groups, some of which will result in more competitive pricing and some in less competitive pricing. This could increase sales in those groups where prices become more competitive but would result in a skewed customer population for the insurer. Underwriting The government could alter any restrictions on the ability of insurers to underwrite policies. For example, a prohibition on the use of the results of genetic testing or prohibition on the use of past claims history or medical history. Requirements that encourage simpler underwriting could work to increase sales by removing the hassle factor but there is a danger that any higher morbidity risk could offset the benefit of lower underwriting costs, which would increase premiums and so not increase sales. Distribution channels Any restrictions on the channels through which the business may be sold could be relaxed. This may allow more customers to have access to these products or give the insurers access to lower cost distribution methods. Page 12

179 Subject ST2 (Life Insurance Specialist Technical) April 2014 Examiners Report Information provided to customers The amount of information that has to be provided to customers at sale could be changed but this would only increase sales if it was a lack of this information or too much information that has been preventing customers from making the final purchase. Premium caps Any caps on premium rates could be revised or removed though this is only likely to result in higher premiums which would only be effective if the cause in decline was due to the products being unprofitable for companies to write rather than due to premiums being too expensive for customers. Reserving requirements Reserving requirements could be relaxed for example reducing the required prudence level or minimum solvency capital requirements could be reduced. This would only be effective if the products were capital intensive, which a lot of life insurance products can be, and would depend on the profit basis on which they were written and whether it was capital constraints that were preventing insurers from actively selling these products. It would also reduce the protection that customers are provided with from prudent reserves, that in turn could reduce customers propensity to buy. Investments The government could relax the investment restrictions that are imposed on companies. This could be by allowing a higher proportion to be invested in riskier or illiquid assets or allowing investment in different/new asset types. This would be effective if this would allow the company to obtain a higher return on the assets backing life insurance products which it could pass onto the customer through lower premiums. This would only be effective if it was high premiums that were causing low sales. Tax The government could alter the tax regime for life insurance products alternatively they could alter the tax regime for other markets to make life insurance more attractive relatively. There are two places where the product could be taxed: at the company level or at the customer level. The government could reduce overall tax on the companies that generally sell these products or it could reduce the tax paid specifically on these products. This could make tax calculations more complicated for the companies, but if customers found products unaffordable before then this is only effective if companies pass on subsidies to customers. Alternatively it could reduce any tax, where it exists, that the customer pays on the benefits from these products, or allow premiums into these products to be income tax free e.g. paid from gross income or be credited with the tax back. Page 13

180 Subject ST2 (Life Insurance Specialist Technical) April 2014 Examiners Report Amending taxation could be effective for either source of the problem, though given the potentially complex nature of implementing this, it would need to be a more permanent feature than a temporary one. The effectiveness would also have to take into account the cost of any related system changes. Commission The government could remove restrictions on the maximum levels of commission that are allowed to be paid on these products. This could aim to boost sales by incentivising advisers to sell them. However, this higher commission is likely to be paid for by customers which could reduce sales. The additional products sold due to this type of incentive could be more likely to lapse if they realise they didn t really need the product originally. It goes against trends in some countries at the moment to reduce commission payments. Compulsory products The government could make the purchase of life insurance products compulsory in certain situations to increase the market, e.g. making life insurance compulsory when taking out a mortgage or requiring employers to take out life cover for their employees. But this could have other consequences, as lower prices may be needed in this situation, since a reasonably high proportion of potential customers may not be able to afford premiums if it was compulsory. Given other restrictions that may be put in place to ensure those that had to buy a life insurance product could afford it, some product providers may choose to not sell these products any more. Subsidies The government could subsidise these products directly by providing a subsidy to the insurer for each policy sold (or amount of benefit). This could be effective if the cause of declining sales was the unprofitability of them to the insurers as this would boost profitability. But if it was customers finding these products unaffordable that caused declining sales, this would only be effective if the insurer passed the benefit of the subsidy onto the customer through lower prices. Advertise The government could invest directly in advertising or an educational programme to promote the benefits of life insurance products. This could help increase sales if it is a lack of awareness that is causing the decline in sales. State provision The government could reduce the provision of State benefits e.g. State pension or raising the means testing limit. This could help provide a larger market, e.g. for life insurance products that provide benefits in retirement. Page 14

181 Subject ST2 (Life Insurance Specialist Technical) April 2014 Examiners Report Help companies The government could implement measures to help new life insurance companies enter the market e.g. by providing start up grants or grants to existing companies or by implementing anti-monopoly/oligopoly legislation or by assisting in the collation of life insurance data to aid pricing of products. Other actions The government could provide free financial advice. They could take actions that improve the general economic state and hence personal wealth so stimulating sales. The government could be guarantor for an insolvency scheme and so increase customer confidence or they could relax restrictions on overseas companies and their access to domestic markets. The highest marks were scored in this question by candidates who considered a broad range of possible actions and expanded each to consider why they would be effective. A number of candidates scored lower marks because they concentrated on discussing possible causes of the lack of confidence and then focussed solely on actions to address this, rather than considering other causes. Other candidates touched on the key themes but marks were then limited as they did not develop these in sufficient depth. END OF EXAMINERS REPORT Page 15

182 INSTITUTE AND FACULTY OF ACTUARIES EXAMINATION 29 September 2014 (pm) Subject ST2 Life 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 five questions, beginning your answer to each question on a new page. 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 from the approved list. ST2 S2014 Institute and Faculty of Actuaries

183 1 A life insurance company is considering whether to include capital units and actuarial funding in the product design for a new unit-linked product. Discuss the advantages and disadvantages that the company should consider. [7] 2 A life insurance company writes a unit-linked endowment assurance product. Under the terms of this product, the customer pays regular premiums which can be invested in a wide range of unit-linked funds. The benefits on surrender and maturity are the value of the units held at the time of claim. The benefit on death is also the value of units held, unless the customer has selected a specific additional amount of life cover. If selected, the additional life cover is charged for by a monthly deduction of units based on the sum at risk. Other than this mortality charge, the only charges are: an annual management charge, which varies by the unit fund(s) selected. surrender penalties in the first few years. It has been proposed that a minimum surrender value guarantee be added to the product for all future new business. The surrender value would now be the greater of the value of units or the sum of the premiums paid up to the surrender date, with no surrender penalty applied. (i) Discuss this suggestion from the perspective of the life insurance company. [13] The insurance company has decided to apply an additional charge in respect of this guaranteed surrender value. (ii) Describe how this charge might be determined. [9] [Total 22] ST2 S2014 2

184 3 (i) Describe the following types of reinsurance: (a) risk premium (b) original terms [9] (ii) Explain why risk premium reinsurance may be appropriate for a life insurance company that is relatively new to the unit-linked market and has limited surplus capital. [4] A life insurance company is considering using one of the following reinsurance options for its single premium whole life assurance business: Option A: risk premium reinsurance on 25% of the sum assured, for which the reinsurer is offering terms of $0.65 per $1 of sum assured; or Option B: original terms reinsurance on a 50% quota share basis, for which the reinsurer will load a 10% margin onto the premium rates. Details of the portfolio to be reinsured (all figures stated before reinsurance) are as follows: Total sum assured = $2.0m Total single premiums = $1.0m Total reserves = $1.2m Each policy can be assumed to have the same ratio of reserves to sum assured. It can be assumed that the single premiums are all received at the same time, that the reserves stated above are calculated as at that time (i.e. immediately after sale) and that the reinsurance transaction would take place also at that time. There is no allowance for any value of in-force asset on the insurance company s balance sheet. (iii) (iv) Determine the immediate impact that Option A would have on the insurance company s balance sheet. [3] Determine the immediate impact that Option B would have on the insurance company s balance sheet. [3] [Total 19] ST2 S PLEASE TURN OVER

185 4 A life insurance company has provided the following data on one of its conventional without profits protection products: Business in-force at year end Number of policies Total sum assured Total annual premium , ,000,129 10,000, , ,550,011 13,755,005 (i) Comment on whether the data appears to be accurate. [3] The company has provided the following additional information: There has been a major rebranding of the product, and additional benefits have been added. This has resulted in the average new business premium per unit of sum assured increasing and the average sum assured being sold also increasing. There have been significant sales since the rebranding. 2,000 new policies have been sold, with new annual premiums of 4.5 million and a total new sum assured of 30.1 million. Due to time constraints, the company has not been able to perform its normal withdrawal analysis. However, previous withdrawals have been around 3% per annum to 5% per annum. (ii) Discuss the further tests which can now be performed on the given data, including the results and likely conclusions of those tests. [9] The company has now offered to provide more detailed information in order to allow better assessment to be made of the accuracy and completeness of the data held in respect of this product. (iii) Describe the additional checks that could be performed, including the information that would be required in order to perform them. [8] [Total 20] 5 (i) Describe the risks to a life insurance company of writing term assurance business. [17] An established credit card company is reviewing the products that it has currently purchased from a life insurance company. (ii) Describe the likely uses that the credit card company may have for term assurance products. [3] (iii) Set out the main features of these products. [8] (iv) Describe the risks to the credit card company of purchasing such products. [4] [Total 32] END OF PAPER ST2 S2014 4

186 INSTITUTE AND FACULTY OF ACTUARIES EXAMINERS REPORT September 2014 examinations Subject ST2 Life Insurance Specialist Technical Introduction The Examiners Report is written by the Principal Examiner with the aim of helping candidates, both those who are sitting the examination for the first time and using past papers as a revision aid and also those who have previously failed the subject. The Examiners are charged by Council with examining the published syllabus. The Examiners have access to the Core Reading, which is designed to interpret the syllabus, and will generally base questions around it but are not required to examine the content of Core Reading specifically or exclusively. For numerical questions the Examiners preferred approach to the solution is reproduced in this report; other valid approaches are given appropriate credit. For essay-style questions, particularly the open-ended questions in the later subjects, the report may contain more points than the Examiners will expect from a solution that scores full marks. The report is written based on the legislative and regulatory context at the date the examination was set. Candidates should take into account the possibility that circumstances may have changed if using these reports for revision. F Layton Chairman of the Board of Examiners December 2014 Institute and Faculty of Actuaries

187 Subject ST2 (Life Insurance Specialist Technical) September 2014 Examiners Report General comments on Subject ST2 The Examiners Report covers more points than would be expected to get full marks. This is so that alternative approaches to questions by different candidates can be accommodated within the marking scheme. Candidates are expected to show knowledge of the relevant content of the Core Reading, but those who tailor their answer to the specifics mentioned in the question will score more highly than those who answer in a more generic way. Comments on the September 2014 paper As with previous papers, questions that focussed on knowledge of the Core Reading were generally well answered. In some questions, such as 3(ii) and 5(iii), candidates tended to focus on the generic ideas rather than applying them specifically to the particular situation. Similarly, where questions required candidates to think more widely or in more depth or detail, such as 3(i), 4(iii) and 5(i), candidates often did not give particularly comprehensive answers. Candidates should use Examiners Reports to practise applying their knowledge to the situations set. Page 2

188 Subject ST2 (Life Insurance Specialist Technical) September 2014 Examiners Report 1 The advantages of capital units and actuarial funding are: Actuarial funding means the company can hold lower reserves and make the product more capital efficient and hence reduce new business strain allowing the company to potentially write higher volumes of new business. Charges and expenses are well matched and in particular the company can recoup initial expenses more quickly than if it did not use capital units. This can result in lower overall charges to the policyholder, which could make the product more attractive or generate higher profits for the company due to better matching or writing higher volumes of business. Close matching of charges to expenses reduces the level investment risk and persistency risk. The design might be similar to products sold by other companies in the market. By having capital units with a higher annual management charge the company will receive a higher fee income (broadly linked to inflation) than from using accumulation units alone. The product may be more marketable than one with a nil (or low) initial allocation. The disadvantages of capital units and actuarial funding are: Capital units make the product more complicated from a systems perspective. E.g. the company may not have the existing systems functionality to allow the purchase of capital then accumulation units. The high charges on the capital units may put customers off. There is a lack of transparency to the policyholder from the high capital unit charges. The lack of transparency makes the product more difficult to communicate to policyholders or make it hard for policyholders to understand. If the policyholder does not understand the product they are purchasing then the company is more at risk from poor selling practices or from poor persistency. As the product is more complicated, this restricts the distribution channels that can be used to sell it. The most likely channel for this product would have to be through insurance intermediaries, tied agents or direct sales force. Page 3

189 Subject ST2 (Life Insurance Specialist Technical) September 2014 Examiners Report The more complicated the product, the more time and effort is required from the sales person to make a sale. Depending upon how the sales person is remunerated this may restrict the level of sales that are achieved. The method requires the application of surrender penalties which may be unattractive to policyholders. Mortality risk increases as the sum at risk will be higher due to a greater discrepancy between the reserves held and the face value of units. There may be regulatory restrictions on the use of capital units. [7] This question was well answered by most candidates, with marks most commonly being missed out on due to candidates not considering a wide enough range of points. Some candidates spent time providing descriptive background on capital units and actuarial funding, which gained no marks, rather than concentrating on the advantages and disadvantages that were asked for in the question. 2 (i) The company would need to decide whether there would be a charge for the guarantee. If an additional charge is not imposed, profit per policy will fall. The addition of this benefit would, in itself, make the contract more attractive to customers. This could lead to a significant increase in sales, which could lead to higher overall profits. The company would need to consider the products offered by competitors. If the competitors offer such a guarantee, then it may be necessary to do this in order to maintain/grow market share. If they do not, then the increase in sales could be significant though the competition may follow suit. However, the marketability of the new product would also depend on the level of additional charges imposed, if any. One practical detail would need to be addressed: whether the guarantee also extends to the maturity benefit. If not, this would lead to significant surrenders late in the contract, if the guarantee was biting. Depending on the extent to which charges are introduced, the surrender value guarantee is likely to increase the non-unit reserves that have to be held and could significantly increase the capital requirements of the contract. The company may not have the capital to support this new business. Page 4

190 Subject ST2 (Life Insurance Specialist Technical) September 2014 Examiners Report There may be increased persistency risk. There is an increased risk from early surrender and not having recouped initial expenses, having removed the surrender penalty. Withdrawal rates may be materially higher than under the previous version of the product, when the guarantee bites and even potentially when it does not bite, due to the removal of the explicit surrender penalties. The company does not have experience of withdrawals under the new design so may have to increase pricing (and reserving) margins. If the company was charging for the guarantee, it would have to monitor its experience and re-price. The proposal also significantly increases the market / investment risk to the insurance company. Policyholders may tend to select against the company by withdrawing when market values are depressed. The introduction of the guaranteed surrender value benefit could also lead to significant lapse and re-entry risk. Particularly from those policyholders who have recently purchased a policy and who may feel they would have preferred the new version. This could result in reputational risk. To prevent this, it may be decided to add the guarantee to existing customers policies. This would be easier if there were no charge, but would add materially to the risk on those policies where the fund value was lower than the guaranteed amount. If no charge is made, then the cost of the guarantee would vary significantly from policy to policy and hence there would be significant cross-subsidies. The company would need to decide whether any charge levied would vary by fund. The cost would be higher for those in higher risk (i.e. most volatile) unit funds. This may provide the policyholder the opportunity to select against the company by choosing high risk funds. This would be exacerbated by the likely higher annual management charge on these funds. The cost would also be higher for those that had selected the additional death benefit, as the mortality deductions would depress the unit value relative to the guaranteed benefit. These cross-subsidies would increase new business mix risk. There are also practical implications; for example, administration systems would need to be changed, as would policy literature. Page 5

191 Subject ST2 (Life Insurance Specialist Technical) September 2014 Examiners Report The company needs to consider the overall development costs required and whether it expects to sell sufficient additional volumes to recoup this. There would be increased operational risk due to the increased complexity, for example, in the valuation. There is a risk from higher than expected new business volumes leading to admin and capital strains. The proposal increases the benefits to the policyholders, so is unlikely to breach any regulatory requirements. If the additional life cover element of the product is reinsured, then the proposal would need to be discussed with the reinsurer. For example, because the level of selective withdrawals might change, so impacting expected mortality. [13] (ii) In theory, a charge could be derived by the use of option market prices. The guarantee can be taken at any time so may need to use an American option or could approximate as a series of put options. If market prices are not available for appropriate options, could consider using a closed form Black-Scholes approach. But the charge is more likely to be determined using a stochastic model. The stochastic model would simulate future investment returns. These simulations would differ for each of the unit funds, e.g. different volatilities. A large number of simulations would be required. Suitable model points would be chosen. The model would project forward the unit fund and premiums and allow for future mortality. The simulated cost of the guarantee at time t is the excess of the guaranteed surrender value (i.e. sum of premiums paid up to time t) over the projected unit value at time t, if this is greater than zero, multiplied by the assumed surrender rate at time t. The surrender rates would need to alter dynamically with the simulations. This is because the likelihood of surrender will increase in simulations where unit values fall below the guaranteed amount. The charge will have to be modelled within the stochastic model as the charge in itself will increase the cost of the guarantee. The charge would most likely be an additional annual management charge. Page 6

192 Subject ST2 (Life Insurance Specialist Technical) September 2014 Examiners Report Sensitivity testing of the deterministic assumptions e.g. mortality, would be performed. The values would be discounted back to time zero. The charge can then be determined so that the present value of the modelled charge equates to the present value of the guarantee averaged across all of the simulations plus a risk loading and possibly also a profit margin. The company would want to compare the final charges against those being charged by its competitors. [9] [Total 22] Part (i) was generally reasonably well answered, particularly by those candidates who were able to provide a wide range of points. The better prepared candidates were able to identify the subtle points around the additional death benefit and the cost being dependent upon the fund choice. Some candidates lost time by focusing on the requirements of a surrender value from the bookwork rather than considering the particular dynamics of the guarantee proposed in the question. Part (ii) was less well answered than part (i), despite being more directly bookwork-based. The better prepared candidates covered both option pricing and stochastic modelling. Marks were missed due to candidates not covering one or both approaches in enough detail for the marks on offer. 3 (i) (a) The cedant company reinsures a percentage of the sum assured or of the sum at risk i.e. the excess of the benefit over reserves on the reinsurer s own risk premium rates, which can be annually renewable or guaranteed. The part to be reinsured can be on an individual surplus (i.e. the reinsured amount is the excess of the original benefit over the cedant s retention limit on any individual life) or a quota share basis (i.e. a specified percentage of each policy is reinsured). The reinsurance company determines its risk premium rates by assessing the likely experience of the business it is to reinsure and then adding expense and profit margins. (b) Also known as co-insurance. All aspects of the contract are shared (including profits and losses). The cedant provides its premium rates to the reinsurer, these premium rates are known as retail rates. The cedant receives commission from the reinsurer. Page 7

193 Subject ST2 (Life Insurance Specialist Technical) September 2014 Examiners Report An alternative approach is where the reinsurer supplies the cedant with a set of premium rates upon which the cedant can load its costs and profit test to get the intended retail rates. This approach has become more common due to the fact that the level of competition in retail markets in recent times requires frequent changes to rates. Original terms can be written on an individual surplus basis or on a quota share basis. [9] (ii) Reinsurance helps to reduce new business strain e.g. through provision of financing commission to enable the company to grow faster and reach critical mass by writing more new business or by writing larger policies and to use the limited available capital to best effect. It can provide the cedant with access to the technical expertise of the reinsurer which will be useful for the company as it will be new to the market and will have no previous experience. The company could use the risk premium rates to price its own mortality charges. Risk premium reinsurance helps the company to build up retained premium income as quickly as possible. Reinsurance helps to reduce any mortality fluctuation risk whilst the portfolio is small. In particular, it helps protect the company against mortality risk arising from a guaranteed minimum death benefit particularly for early duration policies (due to lower unit fund, if regular premium). Original terms reinsurance can be hard to purchase for unit-linked liabilities, so risk premium may therefore be more appropriate this is because under original terms the reinsurer would need to match the unit liability, which can be difficult. [4] (iii) The net liabilities will reduce by $300k (= 25% of the before reinsurance reserves) after reinsurance. Risk premium paid to reinsurer will be $2m 0.25 $0.65 = $325k, and hence assets will reduce by this amount. Overall impact on the balance sheet before tax will therefore be a reduction in surplus assets of $25k. Page 8

194 Subject ST2 (Life Insurance Specialist Technical) September 2014 Examiners Report There may also be a reduction in capital requirements which would offset this fall in surplus assets to some extent. [3] (iv) The reserves after reinsurance will be $600k, i.e. a reduction in liabilities of $600k (=50% of the before reinsurance reserves). Premium income and thus assets will reduce by $550k (= 50% of the total reinsured premium x 1.1 to allow for the reinsurer s margin). Overall impact on the balance sheet before tax will therefore be an increase in surplus assets of $50k. This may be further increased through any reduction in capital requirements. [3] [Total 19] Part (i) was bookwork and was very well answered by a large number of candidates. Where marks were missed, it was due to not including enough detail in the answer (noting the fairly high mark allocation). Part (ii) was reasonably well answered with the better prepared candidates being able to provide a range of points. Marks were missed by candidates not tailoring their answers to the product provided in the question. Parts (iii) and (iv) were not as well answered as expected. A number of candidates thought that the sum assured would be included in the balance sheet or confused the concept of sum assured and reserves, and/or did not consider the reduction in assets from paying the reinsurance premium. 4 (i) The average sum assured at YE 2012 = 9,986 and at YE 2013 = 10,888. The average premium at YE 2012 = 999 and at YE 2013 = 1,222. As at YE 2012 the premium to sum assured ratio is 0.1 and as at YE 2013 this ratio is All of the above look to be material increases and warrant further investigation. Alternatively candidates may have approached the answer in the following way. Increase in the number of policies is 12%. Increase in total premiums is 38%. Increase in total sum assured is 23%. The increase in the premiums is materially higher than the increase in the number of policies and sum assured. This warrants further investigation. [3] Page 9

195 Subject ST2 (Life Insurance Specialist Technical) September 2014 Examiners Report (ii) A data reconciliation should be performed to assess whether the data at previous investigation + new data exits = data at current investigation. We cannot perform this data check precisely as there has been no withdrawal investigation. However we can ascertain the following about the implied policies going off: Numbers off = 10, ,255 = 759. Sum assured off = 100,000, ,100, ,550,011 = 7,550,118. Premiums off = 10,000, ,500,000 13,755,005 = 745,116. The average sum assured going off is 9,947, which is consistent with the YE 2012 in force and suggests accuracy of data. The average premium going off is 982, which is consistent with the YE 2012 in force and suggests accuracy of data. The average premium to sum assured ratio of the implied offs is 0.1, which again is consistent with YE 2012 and supports accuracy of data. The implied withdrawal rate is 759/10,014 = 7.6%, which is higher than in previous years even allowing for the inherent inclusion of deaths. Alternatively candidates may have approached the answer above in the following way: Based on the expected withdrawal experience of around 4%, we would expect the following: Expected numbers at the end = 10, ,000 = 11,613 Expected sum assured at end = 100,000, ,100,000 = 126,100,124 Expected premium at end = 10,000, ,500,000 = 14,100,116 All the above estimates are higher than the actuals, which could mean that actual off rates are higher than historic rates even allowing for the inherent inclusion of deaths. The above analysis may mean that the data is inaccurate or it could mean that there has been some lapse and re-entry with policyholders moving to the new product for the better benefits. This might also be part of the reason behind the high sales. Page 10

196 Subject ST2 (Life Insurance Specialist Technical) September 2014 Examiners Report The average sum assured, average premium and premium to sum assured ratio for new business have all increased. This is consistent with the information provided in relation to the higher benefits sold and the higher cost. Looking at the new business in isolation gives: New business average sum assured is 15,050. New business average premium is 2,250. New business average premium to sum assured ratio is 0.15 or alternatively sum assured to premium ratio is These figures are higher than those in part (i) and so reasonable given the repricing information. [9] (iii) Checks should be made for any unusual values, for example: very large benefit values zero or very small benefit values impossible dates of birth impossible start dates As well as looking at individual values, it may also be possible to group items and look at how well distributed they are. For example, an unusually high clustering of birth month may represent a data input error worthy of further investigation. The information required for the above would be the full policy data with the benefit and date of entry/birth fields populated. It is good practice to compare an extract of the computer held data with the information in the paper administration files. This can be done on a spot check basis by randomly selecting a number of policies. The paper administration files would be required for this check. A major discrepancy or large unexplained in the analysis of surplus compared to previous analyses may indicate a problem with the data. The information required for this is an analysis of surplus, which would mean using both revenue data and experience analyses. Given the time constraints mentioned, such an analysis of surplus may not have been performed. Reconciliations could be performed against other sources e.g. accounting information. In particular, it might be possible to obtain other information (e.g. from claims servicing areas) to determine the actual number of withdrawals in the year. This would therefore allow the reconciliations described in part (ii) to be performed more accurately. Page 11

197 Subject ST2 (Life Insurance Specialist Technical) September 2014 Examiners Report Additional data on the death exits may be required. [8] [Total 20] Question 4 was the least well answered question on the paper. Most candidates were able to score well on part (i). Part (ii) was generally not answered so well as many candidates did not use the information provided in the question to perform numerical sense checks. Two alternative ways of answering part (ii) are included in the solution above; other variations on these approaches were possible and credit was given for them. Part (iii) was reasonably well tackled, but many candidates missed out on marks by not providing a wide enough range of points in their answers (noting the fairly high mark allocation). 5 (i) The main risk to the insurer for term assurance products is mortality risk. In particular, the risk of a higher number of deaths than expected. This could be due to aggregation or concentration of risks and a related catastrophe event e.g. a pandemic. Aggregation and catastrophe risk are increased for group business. Anti-selection risk is an issue for the individual version of the contract, but this is much reduced for the group version. The level of anti-selection risk is linked to the level of underwriting employed by the company. There will also be a mortality risk from selective withdrawals. In particular, the risk that those who withdraw from (or do not renew) the contract are those with lighter overall mortality experience and so the average mortality experience of those remaining increases. There is a financial risk from higher than expected withdrawals at times when the asset share is negative or if lapses occur before the initial expenses are recouped. Especially in the case of decreasing term assurances, if the cost of benefit exceeds the premium being charged early in the term. At later times, if lapses are expected to lead to profits to the insurer (since no payment is made) there is a risk of fewer than expected such lapses. There is an expense risk i.e. that the actual costs of administering the contract are greater than the amounts loaded into the premium. This may also be due to higher than expected inflation. The basic reserves for term assurance contracts are relatively small and fixed interest assets are likely to be held to back them, so investment risk is not likely to be significant. However, there is still a risk that investment returns are lower than expected. There would also be a risk of counterparty default if corporate bonds are held. There is a risk of having inadequate data on which to price the business, particularly mortality data which needs to be relevant to the target market. Page 12

198 Subject ST2 (Life Insurance Specialist Technical) September 2014 Examiners Report There is a risk of selling an adverse mix of new business if cross-subsidies exist in the pricing e.g. selling smaller sum assured business than expected. There is a risk of selling a higher volume of new business than expected, which can cause unexpected capital strain. This is because initial capital strain can arise for regular premium policies due to high initial expenses and solvency capital requirements. Higher than expected new business can also result in administration strain. There is also a risk of selling lower new business volumes than expected, resulting in overheads and fixed expenses not being recovered. New business volume risks are closely linked to risks relating to the actions of competitors e.g. a new entrant taking away market share or an existing company materially reducing its term assurance prices. If options are offered (e.g. convertible term assurances), there is a risk of misestimating the take-up rates if the option is costly to the insurer. And similarly of mis-estimating the level of mortality, allowing for anti-selection, amongst those who convert. There is a risk that the board makes decisions which are not in the long-term interests of the insurer e.g. cutting term assurance premium rates to an unprofitable level. There may be a risk that the distributors mis-sell the business, which could impact the reputation of the insurer. There may be other reputational risks such as the company not paying out on a claim. There may be a risk that policyholders are encouraged by distributors to lapse and re-enter. There may be a risk of non-recovery of outstanding premium balances held by distributors. There is a risk of failure of the underlying systems, e.g. the claims payment process. There is a risk of default of a reinsurer, if reinsurance is used. There is a risk of adverse regulatory changes in relation to term assurances, e.g. introduction of maximum premium rates. There is a risk of adverse taxation changes, e.g. inheritance tax changes can reduce the attractiveness of some term assurance products. There may be a risk of fraudulent activity, e.g. false death claims. Page 13

199 Subject ST2 (Life Insurance Specialist Technical) September 2014 Examiners Report There may be operational risks relating to poor pricing models. Poor documentation or badly worded terms and conditions may result in the company having to pay out on more claims than anticipated. There may be liquidity risk e.g. when unexpectedly having to pay out on a large claim. [17] (ii) There are three uses the company could have for term assurance: To provide protection against the financial loss that might arise on the death of a key person within the organisation. A group equivalent of the term assurance contract can be used to provide a benefit to dependants on the death of an employee whilst in employment. A group version can also be used by this company, to provide a benefit on the death of a customer equal to the balance outstanding on a credit card. This would be needed if no other payment protection was in place and no estate available to pay the debt. [3] (iii) The specified benefit amount is paid out on the death of the specified individual(s) within the specified term of the contract. For key person cover the sum assured will be based on the expected financial loss to the company if that person were to die. This may vary depending on the position and experience of the key person. It may include expected recruitment costs for a replacement. For group term assurance the sum assured will vary by each individual employee and it is usually based on a multiple of the employee s salary. For the credit card protection the sum assured will be based on the potential outstanding balance for each customer. This may be the maximum credit limit on each card or some proportion based on previous experience. There also may be some allowance for whether debt is likely to be paid by either another protection policy or the estate. There may need to be options for all these products to review the sum assured regularly e.g. due to salary rises for group term assurance or increased credit limits for credit card protection. The term will vary by life insured. For the key person the terms are likely to be based on the time to retirement date. For the employee group benefits the policy is likely to be set up on a one year renewable basis. For the credit card protection the term is likely to be substantially shorter possibly with extension options. Page 14

200 Subject ST2 (Life Insurance Specialist Technical) September 2014 Examiners Report It is likely that a conventional without profits basis would be used for all purposes here though an index-linked version would potentially reduce the need to review sum assureds. There is no benefit paid on lapse. Underwriting is performed on key person insurance but little underwriting performed on the others. The product may be compulsory for group death in service benefit. The products are usually regular premium, though as the employee group benefits are likely to be on a one year renewable basis this is effectively a recurrent single premium. [8] (iv) The main risk to the credit card company is that the amount of benefit provided turns out to be insufficient. This is more relevant for the key person and credit card protection products, as the end beneficiary of the group term assurance is the employee s family. Given the potential long-term nature of the contracts, this risk is exacerbated by the effects of inflation over time. If an index-linked version is used, the risk is that the index does not replicate the rate that the benefit needed to increase by. A further risk is that if there is not the ability to review sum assureds regularly then a gap between the amount insured and amount required will grow over time. A subsidiary risk is that the insurer becomes insolvent and unable to meet the guaranteed benefits in full. The credit card company is exposed to the risk of being unable to maintain premiums due to lack of cashflow or due to reviewable premiums increasing materially. The credit card company could also be exposed to the risk of mis-estimating the proportion of deaths where the credit card debt would be paid off using other means, if this has been allowed for in the arrangement. In addition there is a mis-selling risk, i.e. the risk that the credit card company does not fully understand when each of the policies would pay out and so would not be covering the risks it intended to cover. There is a risk of over-insurance on the credit card cover. [4] [Total 32] Part (i) was bookwork and was well answered by most candidates. Stronger candidates were able to explain in sufficient detail why the items they identified were genuine risks. Page 15

201 Subject ST2 (Life Insurance Specialist Technical) September 2014 Examiners Report In part (ii) candidates generally mentioned the use of term assurance for covering the outstanding balance, but only the better answers considered the other uses that a company might have for a term assurance product (noting that the question is asking for uses plural). Part (iii) was reasonably well answered, though only the strongest candidates used the scenario in the question rather than concentrating on the generic term assurance features. Part (iv) was reasonably well answered, with candidates being able to identify the main points but again these were not always considered from the perspective of the full range of term assurance products that could be used. END OF EXAMINERS REPORT Page 16