EXAMINATION. 5 April 2005 (am) Subject SA3 General Insurance Specialist Applications. Time allowed: Three hours INSTRUCTIONS TO THE CANDIDATE

Transcription

1 Faculty of Actuaries Institute of Actuaries EXAMINATION 5 April 2005 (am) Subject SA3 General Insurance Specialist Applications 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 both 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. SA3 A2005 Faculty of Actuaries Institute of Actuaries

2 1 Company A is a large international insurance and reinsurance group whose statutory returns show annual gross earned premiums in excess of $5,000m. The company writes all classes of business from a large number of offices widely spread across the globe. You are an actuary within Company A. The company measures the performance of its underwriters on taxable profit, including credit for investment return. Investment return is credited at a notional rate of interest decided before the start of the financial year. Company A is aiming to increase taxable profit in the next financial year. The budget for each portfolio of business written in Company A must be submitted in June so that the group can finalise the overall figures by the end of July. The underwriting manager of a niche commercial insurance business within Company A is responsible for $200m of annual gross premium which has been stable at this level for many years. Company A has set a budgetary target for this portfolio of increasing taxable profit from $20m to $24m in the next financial year. This business is underwritten in 6 offices each of which operates in a different country. Over half of this business is written in the London Market. Most of the policies in this portfolio have two year exposures and the risk exposure increases from zero at a uniform rate over the policy period. Policies are written evenly over the course of the year. For this portfolio acquisition costs have consistently been 20% of gross premiums and reinsurance spend has been 17% of premiums. The reinsurance has been well used and in the manager s opinion has been key to smoothing profits. Company A has asked the underwriting manager to halve the amount of reinsurance purchased. Internal expenses have been cut over the past two years from 15% to the current year budget figure of 13% of gross premiums. The mean duration of claim settlement is four years from policy inception. This underwriting manager has asked you for a report outlining the options open to him to achieve the company profit target explaining the advantages and disadvantages of the options. (i) Discuss the possible options open to him that you would consider for your report. [47] The underwriting manager has expressed dissatisfaction at the rate of investment return credit, telling you that he is getting more on his own fixed interest investments. He also disagrees with Company A s decision to cut his reinsurance spend by a half. (ii) Explain why the underwriting manager s view may be different from Company A s view. [18] [Total 65] SA3 A2005 2

3 2 The FSA is in the process of changing the capital requirements from solvency margin to Individual Capital Assessment (ICA). (i) Describe the core elements of the new proposals under the headings of ECR, ICA and ICG. [4] (ii) Describe the three components of the ECR calculation. [4] (iii) (iv) (v) Discuss the advantages and disadvantages to a general insurance company of ICA compared with ECR. [6] Outline the main areas that are expected to be covered in the ICA format proposed by the FSA. [9] For each of the risk types itemised under these proposals: (a) State each risk and suggest a basis for modelling each of them. (vi) (b) Explain, with examples, how each risk may be correlated with the others. [7] You are the actuary for a London market company writing commercial property business both insurance and reinsurance. Describe how you would parameterise the model of the insurance risk. [5] [Total 35] END OF PAPER SA3 A2005 3

4 Faculty of Actuaries Institute of Actuaries EXAMINATION April 2005 Subject SA3 General Insurance Specialist Applications EXAMINERS REPORT Introduction The attached subject report has been written by the Principal Examiner with the aim of helping candidates. The questions and comments are based around Core Reading as the interpretation of the syllabus to which the examiners are working. They have however given credit for any alternative approach or interpretation which they consider to be reasonable. M Flaherty Chairman of the Board of Examiners 28 June 2005 Faculty of Actuaries Institute of Actuaries

5 Subject SA3 (General Insurance Specialist Applications) April 2005 Examiners Report 1 The examiners were generally disappointed with the majority of solutions given to this question. In particular there was a lot of information given in the question which many candidates did not seem to use to form their solution. There were several references to figures in the question which candidates did not refer to in their answers, in particular regarding the pattern of earning of premium, and the value for money of reinsurance. Owing to the lack of reference to information given candidates did not gain marks for mentioning the likely relevance of some of their options in achieving the target profit. When candidates did mention the possibilities of meeting the target many considered the long term rather than the short time window of the next financial year. Hence some of the solutions suggested options which would not deliver the profit target in the following year. Their seemed to be very little reference to the fact that the expense action already taken may not have been fully reflected in the profit figure and hence this was a source of further improvement for the following year. Some candidates seemed to be unsure what areas of the business the underwriter would be able to influence. Solutions to part (ii) were generally very good. (i) Options which could increase earned profit next year are: 1. Increasing written and therefore earned premium. 2. Reducing acquisition expenses. 3. Reducing internal expenses. 4. Reduce the cost of reinsurance. 5. Writing to a lower loss ratio (for new / renewing business). 6. Reduce the cost of claims for claims settling next year. 7. Speeding up the earnings pattern of the portfolio. 8. Getting a higher investment credit. 9. Change to reserve assumptions and methodology. For each option assume everything else unchanged: 1. For two year policies: earned in yr 1 = 50% * 1yr * 50% pol exposure = 25%. Therefore 75% earned in year 2. (At 18 mths = 50% * 1.5yr * 75% pol exposure = 56% ) Policies to be written in the forthcoming year will commence uniformly over the year and will on average be written half way through the year. They will thus be exposed for a quarter of their policy term. In the Page 2

6 Subject SA3 (General Insurance Specialist Applications) April 2005 Examiners Report 2. following year the earned premium on these policies will thus be 6.25% of that written. The portfolio premium would need to grow by $640m. This is a very substantial increase which may be part of the plan for this portfolio. But may not be previously planned and could be a tough target. Can the individual markets/offices deliver this? Increase in premium likely to be restricted as niche market. Over half is written in the London Market subscription market therefore could increase its written lines on business. But the company could be already writing large lines with cedants and brokers unwilling to give Co A larger lines. The company could also write larger risks Could diversify the types of risks written and by channel Would the loss ratio suffer by taking on larger volumes of business which may not be as good quality as the existing business. Would the acquisition costs suffer by accepting business from higher cost sources. Can the front office / back office cope? Would direct expenses increase to cope with the new volume? Will the reinsurance programme be as efficient? How does the RI premium adjust? Will RI aggregates be breached? How does the new volume and business mix compare to the RI submission information? Will the terms of the RI treaty have to be renegotiated? May breach statutory premium limits in some countries. Requiring the injection of capital into some countries. Acquisition expenses will be different from the different sources. Some sources will be higher than others. Some may be relatively very expensive. Page 3

7 Subject SA3 (General Insurance Specialist Applications) April 2005 Examiners Report 3. Could cut the amount of business from the highest cost sources. This may improve the percentage profit but not necessarily the absolute profit Could take a tough negotiating stand with all brokers to cut brokerage. Which may be possible if the company dominates this niche market. But may result in lower volumes if the brokers can place the business elsewhere. Restructure commission arrangements to give incentive to provide higher volumes However there are sensitivities regarding volume related commissions (Spitzer) Could push for (more) direct business with very low acquisition costs. But again this may annoy brokers who may take business elsewhere. Could make commissions profit related so higher commissions only paid on profitable business. But this will reduce the benefit of better business. Reduced over the last two years made? have all efficiency savings already be It has taken 2 years to reduce expenses by 2%, there may be some savings in the next year from previous/current actions. You are unlikely to achieve the full 20% improvement with expenses alone, however a further 1% reduction in expense ratio would contribute $2m to the required increase in profit. Niche product, therefore specialists required in underwriting / claims, massive savings probably not possible. Internal expenses consist of direct and indirect, much of the internal expense will be out of the control of the portfolio manager. Closing an office or other drastic measure would probably not deliver the earned profit in the required timescale redundancy payments etc. Page 4

8 Subject SA3 (General Insurance Specialist Applications) April 2005 Examiners Report 4. Introduce new admin procedures to cut costs, but again this is unlikely to be achievable in the required timescale. RI well used and key to smoothing profits so we expect a fairly high recovery rate, assume 50%, but could be higher or lower. Must reduce the net cost of the reinsurance, so take into account reinsurance recoveries as well as the outward premium. Not buying any RI would not reduce the costs by 17%. If recoveries average 50% then cutting all RI would be expected to increase profit by 8.5%. Reinsurance outward premium is $200m * 17% = 34m assuming 50% recovery means that the cost will be $17m. Halving the reinsurance spend will reduce the cost from 17m to 8.5m increasing profits by 8.5m. RI looks to be the solution to the manager s problem so we need to know what the current arrangement is and what loss ratio it is running at. Depending upon the insurance cycle may be able to cut reinsurance premiums payable. It is possible, but unlikely, that reinsurance provides a net benefit to the portfolio. Need to know when the RI incepts and any existing agreements if incepts mid year then will only be able to reduce the costs for a part year. Long term agreements may mean that no changes are possible. Reducing Xol reinsurance spend will increase the % volatility of the account. If Xol Reinsurance cover is reduced by: cncreasing retention reducing the limit or retaining a self insured share across the programme Purchase reinsurance in-house and avoid paying brokerage. Reducing QS reinsurance spend will not change the % volatility of the account. Ads / disads. This may not be what the manager is comfortable with. Manager may prefer a less volatile / more certain result. Page 5

9 Subject SA3 (General Insurance Specialist Applications) April 2005 Examiners Report 5. Reducing the amount of reinsurance purchased may reduce the other perceived benefits obtained from reinsurers e.g. market knowledge. Purchasing less reinsurance might also lead to higher capital requirements. Could write business to a lower Loss Ratio by tightening policy conditions, increasing rates, and better risk selection. However, the team should already be writing the best business they can so this could be a difficult task. Increasing premiums may lead to loss in business overall, depends upon elasticity of demand. Alternatively the LOB may be writing to significant losses. So improvement should be much easier. The market cycle may be hardening making the task easier, or v.v. It may be possible to be more rigorous with renewals, exiting poor business. Statistical analysis of data may identify both good and bad business which could be targeted for appropriate action. But writing higher business volumes works against writing to lower loss ratios. May identify one office with a higher loss ratio, leading to difficult decisions which the manager may not want to take. May mean axing some policies which have been written for many years, and breaking longstanding relationships difficult. Page 6

10 Subject SA3 (General Insurance Specialist Applications) April 2005 Examiners Report Profit is measured on an earned basis. So reducing incurred claims next year would increase profits. Reduce margins in reserves would increase taxable profit in that year, although this would increase the risk of reserve inadequacy. Could be more active in claims adjusting, settling outstanding claims for less. This may be possible in a specialist / niche LOB. But this should be being done already. This may increase loss adjustment expenses. But should be more than compensated by lower claims. But the strategy may not be successful. Accelerating the earnings pattern of new / renewing business will accelerate earned premium next year. Thus accelerating earned profit. Assuming business written to a profit. But this can only be done once per policy. But may not be possible in this niche Lob. Not a lot can be achieved here. Investment return is credited according to a company allocation. This may be achievable but is not an exercise which adds value to company A. It benefits the manager at the expense of someone else. Increasing this portfolio s credit would mean reducing the credit for another portfolio. If the total investment return is to equal that earned. Page 7

11 Subject SA3 (General Insurance Specialist Applications) April 2005 Examiners Report Change Reserving Methodology to reduce claims incurred in the financial year (or their present value). The extent to which this may be possible depends on the manager s sphere of responsibility or influence and the legal constraints in the territories concerned. Discount reserves at a higher rate of interest if this is allowed. Extend mean duration of discounted business slower payout pattern. discount according to a Reduce case estimates. The above may be perfectly legal if a conservative approach is currently taken, but care does need to be taken. These options do not add value to Company A, they impact the timing of the emergence of profit. (ii) Conflicts of interest / opposing views Reinsurance spend Investment return 1. RI Spend Manager views RI as crucial to smoothing results. Elimination of large losses is achieved by Xol not QS RI. 17% of $200m is $34m which is a large cash spend. What the manager views as a large loss may be insignificant to the company. Manager may be buying down to very low retentions which Company A would rather retain. Manager may be protecting events which may be more efficiently protected at group level. This may be even more acute for the smallest premium volume offices where a moderate sized claim could lead to an underwriting loss. Reinsurers aim to make a profit so the manager is ceding profit over the long term. RI arrangements could involve funded/finite deals which smooth profits but do not benefit Company A. Ceded RI may be with companies less financially secure than Company A. Page 8

12 Subject SA3 (General Insurance Specialist Applications) April 2005 Examiners Report Some RI purchases may have more to do with relationships than any added value. 2. Investment return Not a function of underwriting so can argue should not be part of the performance assessment. Manager may not be taking into account currency matching of reserves or matching by duration. Some currencies e.g. Japan, USA have much lower interest rates than the UK. London Market business does not have to be denominated. Matching investments by duration, the manager s view may be much shorter term. Investment managers should have their own targets, LOBs should not benefit / suffer from any deviation from target by the investment managers. Managers view may not take into account the investment costs. Or the investible percentage of funds. The quality of investments may be different. The company is not necessarily invested in fixed interest investments and for the time being return on their investment return is set at a lower notional rate but in the long term will be higher. May be regulatory restriction for the company on what they can invest in and this affecting the notional return. Effect of tax on investment returns may be strict for the company than the individual thus affecting net of tax return. 2 The better candidates showed that they had both read the notes and could demonstrate an understanding of the bookwork, and that they had prepared for the exam by reading around the subject in respect of important factors affecting the GI industry at the moment. The examiners were disappointed to see though that a number of candidates did not appear to have studied the course notes on this subject. Page 9

13 Subject SA3 (General Insurance Specialist Applications) April 2005 Examiners Report (i) (1) A new risk-based enhanced capital requirement (ECR) based on capital charges to be applied to asset values and insurance premiums and reserves. (2) Insurers will be required to undertake their own assessment of their capital needs according to the size and nature of their business taking into account major sources of risk (including systems and controls and operational risk) and calculate their individual capital assessment (ICA) using either stress and scenario tests or stochastic modelling. FSA guidelines state the minimum risk appetite should be 99.5% confidence of capital adequacy over a 1 year time horizon (3) Individual capital guidance (ICG) will be set by the FSA. ICG is based on the FSA s own view of how much capital individual insurers should hold, taking into account insurers assessments of their own capital needs, risk and capital management processes. ECR ICA ICG (ii) The ECR is an FSA-prescribed, risk-sensitive calculation, made up of the sum of various capital charges based on asset categories and underwriting risk: Asset-related values related asset factor (%) Insurance related values relevant technical provisions factors (%) Net written premium relevant premium factors (%) Asset-related values are calculated after the application of valuation and admissibility rules. Insurance-related values comprise (for each class of business), the total technical provisions, including outstanding claims, IBNR and IBNER claims, unearned premiums reserves and any additional unexpired risk reserves. Claims reserves are net of anticipated reinsurance recoveries and premium reserves are net of deferred acquisition costs. Premium values are gross written premiums net of reinsurance but before deduction of commission. Page 10

14 Subject SA3 (General Insurance Specialist Applications) April 2005 Examiners Report (iii) Advantages Risk based so assessment and framework needed so controls and systems. Company specific data can be usetd so should be more accurate. Company calculates so forces to assess and understand the risks in more detail may lead to better management. Rigorous documentation. Company can continuously monitor the amount they need and calculate changes from changes in strategy i.e. buying more reinsurance changing portfolio of business previous backward looking. Higher level of capital may reduce insolvencies. ICA does not penalise conservatively reserved and sufficiently premium rated companies. Disadvantages Complex, difficult to model and to validate model, i.e. higher costs etc. May not be transparent. Different companies may take different approach to modelling assumptions (for example tails or correlations), which may lead to different levels of capital being set. Need lots of data. Even with large database some risks are very subjective for example cats and operational risk. Expected higher capital may put UK companies at a disadvantage in producing returns for shareholders. (iv) A summary of the financial position of the firm at the time the report is constructed and the risks to which the firm is subject. The firm s proposal for ICA expressed as a proportion of its ECR calculation. Relevant historical development of the firm and any conclusions that can be drawn from that development which may have implications for the future of the firm. Page 11

15 Subject SA3 (General Insurance Specialist Applications) April 2005 Examiners Report The business profile of the firm, the environment in which it expects to operate, and its projected business plans, projected financial position and future sources of capital. A detailed review of the capital adequacy of the firm. This analysis could include a commentary and opinion on the applicability of the ECR to the firm s own capital position and its appropriateness compared to its own capital assessment. It could involve an analysis of the current capital levels and movements in solvency levels during the past years, future capital requirements, and general outlook. An identification of the major risks faced in each of the following categories: credit risk, market risk, insurance risk, operational risk liquidity risk and group risk, and the extent to which a firm holds capital in response to each risk. The quantitative results of stress tests and scenario analyses carried out by the firm and the confidence levels and key assumptions behind those analyses. Identification of any risks (for example, systems and controls weaknesses) which in the firm s opinion are not adequately captured by the ECR and the firm s assessment of how the firm is responding to those risks and if through holding capital, the amount. If the firm uses more sophisticated modelling approaches, the FSA would also expect a statement on the confidence level and other parameters that have been used in the model. (v) Market risk This risk could be modelled using an economic model that would enable a stochastic asset valuation at the end of the period by simulating returns for each asset type. Alternatively could use asset movement stress and scenario testing. Such risk could be correlated with insurance risk as dependent upon inflation. Also could be correlated to liquidity risk for example in the case of reinsurance failure. Insurance Risk This risk is likely to separate catastrophe claims experience from attritional experience. Likely to model risk in respect of claims, reserves etc using ECM (economic capital model). Correlations with most other risks, e.g credit risk following effect of cat claim, liquidity risk for reinsurance failure Credit Risk Simulate counterparty risk using an ECM stress and scenario test. Credit risk arising from a reinsurer failure could have an impact on other insureers leading to a market risk, and also as mentioned above could lead to a liquidity risk. Liquidity Risk In this case would likely to produce a cashflow model. As stated above this is closely linked to insurance risk if large claim occurs. Page 12

16 Subject SA3 (General Insurance Specialist Applications) April 2005 Examiners Report Group Risk In this case each part of the group would be modelled separately, i.e. parent or subsidiaries. There is a link here with market risk if an event takes place that affects all areas of the group. Operational Risk This risk is likely to occur as a result of poor management leading to monetary loss. As such stres and scenarion testing against the risk register is likely to be used there is a correlation with Insurance risk as bad management could lead to high loss ratios. (vi) For the insurance risk need a frequency severity model. Model gross claims and also insurance and inwards reinsurance separately. Most likely to model attritional, large and cat losses separately. Use historic data converted to current times allowing for claims inflation, line size change, profile of the account and rate changes (to capture relative exposure), and insurance cycle. This will allow an estimate of freq and severity for the large loss, and distribution for the attritional claims. Parameters of the distributions should be varied and parameters should be estimated by fitting distributions to the data using goodness of fit tests. RMS or other cat modelling software can be used for the cat part. The assumptions should be discussed with management and the underwriters and checked against the business plan. This gives the gross losses. Set up a stochastic model and model explicitly any recoveries from the reinsurance program including reinstatement premiums. Page 13

17 Faculty of Actuaries Institute of Actuaries EXAMINATION 6 September 2005 (am) Subject SA3 General Insurance Specialist Applications 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 both 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. SA3 S2005 Faculty of Actuaries Institute of Actuaries

18 1 You are a consulting actuary for a medium sized UK general insurance company writing personal and commercial motor, household buildings and contents, commercial property, employers liability, public liability and professional indemnity business. The company does not write reinsurance business and the business consists mainly of UK risks. (i) (ii) Discuss the likelihood of occurrence of large individual claims and catastrophes in each of the company s classes of business, giving examples of how they may arise in each case. [16] Explain why it may be necessary for this company to adjust claims data for pricing and reserving in respect of large individual claims and catastrophes. [8] (iii) (a) Describe different ways of defining and treating large individual claims when considering the extraction of them from the claims triangulations for the purposes of establishing reserve requirements for the personal motor business. (b) Set out the advantages and disadvantages of each approach. [15] In June 2002 the company recruited a new senior claims handler with responsibility for improving the company s motor bodily injury claims reserving. Within six months of joining the company the new recruit had implemented new claims handling practices and had reviewed all claims larger than 50,000. The company believes this review was responsible for significant increases in case estimate amounts. You have been asked to review the company s personal motor reserve projections. The methodology has been to remove claims with incurred cost greater than 100,000 from the claims triangles, project non-large claims using standard chain ladder methodologies and include reserves for the large losses as the sum of the large loss case estimates. You have been provided with the large claim listing shown opposite in respect of the personal motor classes of business. Total paid claims in respect of these large losses amount to 3,339,000 as at 31 December (iv) (v) Explain the disadvantages of the company s approach to reserving for this personal motor account. [5] Estimate a gross of reinsurance claims reserve for the personal motor large claims using the claims information above, including an allowance for the future emergence of large claims in relation to expired risk as at 31 December 2004, explaining any assumptions made. [16] [Total 60] SA3 S2005 2

19 Notified claims at year-end ( 000) Date of Loss /02/ /05/ /06/ /11/ total /01/ /04/ total /03/ /05/ /08/ /09/ /12/ total /07/ /10/ /12/ total /03/ /05/ /11/ /12/ total /02/ /02/ total /06/ total 400 All losses SA3 S PLEASE TURN OVER

20 2 You are the actuary for a proprietary company, company Z, based in the UK, which writes only treaty reinsurance business, but does not write retrocession business. The company will consider writing reinsurance of any standard class of general insurance business. It currently underwrites a small (around 100) number of large treaties, both on a proportional and non-proportional basis. The company s senior management has requested that the monthly management information reports provided are changed to provide clearer output upon which to base their decisions. The first request that has been made is to provide an index, which will illustrate the average year-on-year change in expected profitability to the company of each contract written, sub-divided by line of reinsurance business written. (i) (ii) Discuss how you may go about constructing such an index, detailing the following: the issues you would consider assumptions that you would make the data that you would require the limitations that you would wish to highlight to the senior management [25] Suggest the sorts of other management information with regards to the underwriting and claims processes that could be usefully monitored on a monthly basis for this type of reinsurance company. [6] One of the company s cedants buys an excess of loss policy with four reinstatements from company Z, each at 100% of original premium. They have asked whether your company can provide a form of insurance known as reinstatement premium protection, which would cover their obligations to pay reinstatement premiums in the event of them making a claim on the original policy. (iii) Compare this reinstatement premium protection approach with the alternative of adjusting the original contract to provide free reinstatements. [5] The original contract provides 1 million of cover with four reinstatements. The reinstatements are for the same amount as the original contract 250,000 each. Loadings to the risk premium make up 20% of the price actually charged. (iv) Calculate the theoretical risk premium for the reinstatement premium protection cover, if it covers one loss with three paid reinstatements at 100% of original premium. [4] [Total 40] END OF PAPER SA3 S2005 4

21 Faculty of Actuaries Institute of Actuaries EXAMINATION September 2005 Subject SA3 General Insurance Specialist Applications EXAMINERS REPORT Introduction The attached subject report has been written by the Principal Examiner with the aim of helping candidates. The questions and comments are based around Core Reading as the interpretation of the syllabus to which the examiners are working. They have however given credit for any alternative approach or interpretation which they consider to be reasonable. M Flaherty Chairman of the Board of Examiners 29 November 2005 Faculty of Actuaries Institute of Actuaries

22 Subject SA3 (General Insurance Specialist Applications) September 2005 Examiners Report 1 The examiners were generally disappointed with the answers to this question. Although most candidates managed to answer part (i) reasonably well there were generally very poor solutions given regarding how to deal with large claims in parts (ii) and (iii). Part (v) was also badly answered with many candidates blindly using the Chain Ladder method without consideration of the data available. A few candidates could not even use the Chain Ladder correctly which is very basic methodology for GI reserving. Ignoring the data given in part (v) and inventing own data did not gain any marks. The use of abbreviations without definitions does not help the examiners in assessing if the candidate understands the issues being considered. Using non-standard abbreviations even if definitions are given is not welcomed. The increase usage of text speak is also most unwelcome as such speak would not be tolerated in the business environment. (i) Personal and commercial motor Might expect a reasonable proportion of total claims cost to arise from large individual claims greater than 100,000 Large individual claims are likely to arise due to bodily injury rather than due to property damage (unless very high value or large commercial vehicles) Likelihood of large claim usually higher for commercial owing to mileage driven, although will depend upon experience of driver Likelihood of large claim higher for young drivers which may generally have non-comp rather than comp insurance Likelihood of large claims is increasing owing to Court Awards and general litigiousness Catastrophes may arise from, say, a motorway pile up or weather events such as floods Potential accumulation of risk is greater for Commercial Motor although these are likely to have less impact on overall claims costs than large individual claims Household buildings and contents Most household contents claims are small as mostly property damage claims More household buildings claims are large e.g. total destruction due to fire, or total rebuild for subsidence But generally the proportion of large individual claims is smaller than for motor (or some other valid comment about relativity to other classes) Catastrophes are a significant feature for household insurance, being a key driver of profitability for a particular accident year These generally arise due to weather conditions such as flood, storm, freeze Subsidence claims are not generally particularly large (on average about 10,000). Page 2

23 Subject SA3 (General Insurance Specialist Applications) September 2005 Examiners Report although they tend to aggregate regionally (due to type of soil). and their occurrence is strongly linked to weather conditions and therefore a bad year for subsidence may be considered a catastrophe year Possibility, although very unlikely to have a large PL claim Commercial property Large individual commercial property claims are common As a proportion of total claims cost large individual claims are more significant for this class than for motor or household (or some other valid comment about relativity to other classes) Potential for very large claims depends on nature of portfolio (e.g. retail, industrial, small/medium/large assureds) Large claims can arise when there is significant property damage E.g. fire resulting in destruction of whole building But also from business interruption claims if this cover is included within the contract Catastrophes generally arise due to weather conditions Potential for accumulation of losses owing to proximity of risks Employers liability Employers liability gives rise to bodily injury claims of various sizes, including some very large ones Large individual claims can arise where bodily injury is such that cost of medical care is very high e.g. back injuries or employee s salary is high or employee is young and therefore loss of future earnings when unable to work is high The most serious asbestos-exposure claims (e.g. mesothelioma) can give rise to individual claims in excess of 100k The likelihood of some large claims (e.g. asbestos) will depend upon size of past exposure and trades covered Occasionally catastrophes can affect this class, although this is less of a feature than for household business (or some other valid comment about relativity to other classes) E.g. Piper Alpha oil rig disaster in 1988 did find its way into employers liability accounts / other suitable example Catastrophes will depend upon trades covered Public liability Public liability gives rise to property damage and bodily injury claims of various sizes, including some very large ones Likelihood will depend upon business covered, e.g. major sporting event Claim size distribution is generally more skew for public liability than for employers liability Page 3

24 Subject SA3 (General Insurance Specialist Applications) September 2005 Examiners Report Sometimes public liability includes product liability cover; this can lead to aggregation of claims (e.g. product recall) or large individual claims (e.g. pharmaceutical products) Professional indemnity Claim sizes generally depends on professions covered within account Likelihood of a large claim depends upon policy terms and conditions and generally frequency is more variable than for other classes A professional negligence claim against a large firm of accountants may result in a very large claim if a company became insolvent as a result of negligent advice Market-wide issues such as pensions misselling claims on professional indemnity for IFA s, may be considered as catastrophe claims (ii) Outstanding Claims Reserves calculations If left unadjusted in aggregate data, individual large claims might distort the projection of the OCR This is the case if individual large claims have a different claims development pattern than non-large claims. and the mix of non-large and large claims varies from year to year (due to random large loss experience i.e. if frequency of large claims is low)...then leaving large claims in the aggregate data could result in unstable chain ladder development factors and average development factors for each development year might be distorted by unusually high or low large loss experience in recent years and even when the averages are not distorted, applying an average chain ladder development factor might be inappropriate for those years of account with unusually high or low large loss experience. Catastrophes can cause a similar problem to individual large claims although the various individual claims arising from a catastrophe may develop at a similar speed to non-catastrophe claims they may bias the average date of occurrence e.g. storm occurring at the end of an accident year for the household account might result in year being less mature than normal claims resulting from storm and flood catastrophes tend to be reported very quickly and therefore distort reporting pattern, whereas claims from subsidence catastrophe tend to be reported quite slowly splitting of such claims leads to greater accuracy within modelling Catastrophes may lead to greater claims leakage owing to pressure of making payments this distorting the true payments pattern The inflationary effect on a large claim is likely to be different to that on smaller claims Page 4

25 Subject SA3 (General Insurance Specialist Applications) September 2005 Examiners Report Rating factor relativities If left unadjusted in aggregate data, individual large claims would unduly dominate the experience of the risk group. and might lead to inequitable pricing which in turn might lead to antiselection This is particularly relevant for rating cells/risk groups with lower volumes of data e.g. 80 year old drivers for private motor insurance where the presence of a large claim is more due to random occurrence rather than systematically bad experience Could create non-competitive premiums Reinsurance calculations It might be necessary to assess current and future recoveries on excess of loss and catastrophe reinsurances And this may be easier to do by removing the elements of large claims that are recoverable and projecting them separately (iii) There are various different ways that large losses can be extracted from the claims triangulations and there are different definitions for a large individual claim Different extraction approaches include: 1. Do not extract large claims from data + Simple and quick + Fairly robust if large claims experience has been fairly stable from year to year + Ensures reasonable allowance for unreported large claims May result in over/underestimation of IBNR if large loss experience has not been stable Does not recognise trends in large claim experience 2. Extract whole of each large claim and associated history if its incurred claim amount exceeds a certain threshold e.g. 100,000 + Non-large claims triangulation is not distorted by part-history of large claims Will need to restate history of non-large triangulation each year as non-large claims become large So difficult to reconcile with last year s data Difficult to allow for claims currently classified as non-large to become large Page 5

26 Subject SA3 (General Insurance Specialist Applications) September 2005 Examiners Report 3. Once large always large => even if incurred claims for a loss falls back below threshold, still treat as large + Reduces need to amend history of non-large triangulation each year + Recognises the potential for large claims to become non-large and therefore avoids over-estimation of reserves for large losses May distort any large claim average cost analysis 4. Only extract claim from the point that it become large i.e. history of claim before large remains in the aggregate data + No need to amend history of non-large triangulation each year May be sharp reductions in claims in non-large triangle from one development year to next Development factors that rely too heavily on such an instance would result in optimistic non-large IBNR estimate 5. Apply indexing to the large claim definition e.g. 100,000 for losses occurring in 2000, 105,000 for losses in 2001 etc. + Ensures that large loss definition maintains real value over time + If there were no indexation, there would be very few claims extracted from early years of account compared to later years and this would reliability of development analysis + Can make definition coincide with excess point for excess of loss reinsurance Indexation introduces complexity Inflation hard to measure 6. Only extract the part of each large individual claim that is in excess of the threshold + The non-large aggregate claims history does not then change over time + If threshold is in line with excess point for excess of loss reinsurance, then reinsurance IBNR can be identified more easily Might be harder for systems to extract the excess over the threshold (iv) Depending on exactly how the large claims have been extracted, there may be no explicit allowance for non-large claims to become large There is no allowance for unreported large claims and the large claims listing clearly shows that some large claims do not become so until 2 or 3 years after the accident date There is no allowance for development of existing large claims Page 6

27 Subject SA3 (General Insurance Specialist Applications) September 2005 Examiners Report Although the case reserving may be stronger since the arrival of the new claims handler, there is still potential for case reserves to increase eg due to unforeseen deterioration in medical condition but there is also evidence of case reserve reduction in later years as some claims are settled favourably Chain ladder methodologies on the non-large claims may not be appropriate for the more recent years of account As development factors applied may be quite large And no use is made of exposure information such as premiums or vehicle years There is no indexation of large losses General comments about the disadvantages of the Standard Chain Ladder method (v) Chain ladder methods less likely to be as reliable as claims handling practices, and hence shape of development curve, have changed Reasonable to take ultimates on as current incurred as little evidence to suggest that there is development after year 4.=> 5505 total ultimate for For the 2000 and 2001 accident years, calculate the % developed at development year 3 over current incurred: ( )/( ) = 97% Apply this to the 2002 total developed at year 3 to estimate unltimate incurred as 1204/0.97 = 1241 Pure IBNR Need to allow for pure IBNR i.e. large losses not on the list but which have occurred prior to 31 December 2004 Use an average frequency average cost approach No details about premium volumes/size of account over time so assume stable Calculate current average claim numbers and average cost each accident year correct numbers below give From table, large losses appear to be notified within 3 years of start of accident year Therefore establish average number of claims in years as fully developed in terms of number of claims = 3.6 But allow for fact that large loss definition has not been inflation adjusted => round up to and 2004 notifications to date do not appear out of line with this total annual number of claims From table, large losses appear to be mostly developed within 4 years of start of accident year Therefore establish average cost of claims in each of years as fairly fully developed in terms of cost of claims correct numbers below give Page 7

28 Subject SA3 (General Insurance Specialist Applications) September 2005 Examiners Report Large claim definition has not been inflation-adjusted so need to allow for effect of inflation E.g. at 7% for motor (or something similar) correct numbers below give Gives average of 599 in 2004 terms Multiply by 4 claims to get est for 2003 and 2004 correct numbers below give Reserve calculation Total ultimates of Total paid of Reserve of 8,199,000 Acc Yr No. Av Cost Future no. 7% Inflation adj Avg Cost Current incurred Current incurred Current incurred Current incurred Incurred / Avg Sel Ult 2 This question was also generally not well answered. The level od detail given by most candidates in the main part of their solutions fell well short of what was expected to gain sufficient marks to pass. (i) Quite possible that the data does not yet exist to do this accurately Should examine the data available and identify gaps for further review Impact split between change in value of treaty, and change in value of underlying There is a requirement to allow for year on year changes in expense allocation There is a requirement to allow for year on year changes in cost of capital Change in value made up of price and T&C For treaty itself T&C changes could include: Page 8

29 Subject SA3 (General Insurance Specialist Applications) September 2005 Examiners Report For non-proportional Per claim limit Feed from pricing model or apply increased limit factors from external data Per claim excess Feed from pricing model or apply increased limit factors from external data Aggregate limit Needs explicit pricing stochastic model ideal stress test if not priced stochastically Aggregate deductible Needs explicit pricing stochastic model ideal stress test if not priced stochastically Per event limit Approximate adjustment based on historical catastrophe experience Types of claim covered Market data apply external benchmarks for new/discarded heads of claim Territory covered Market data apply external benchmarks for new/old territories Term of policy Longer inflation adjustment Inflation clauses (e.g. severe inflation clause) Can adjust value compared to inflation assumptions actually made Profit commission Calculate explicitly based upon expected results + stress test Brokerage Calculate explicitly as discount/load to price Risks attaching/losses occurring nature Calculate approximate change in earnings profile to assess change Reinstatement terms Calculate explicitly using pricing model assumptions For Proportional Profit commission Calculate explicitly as discount/load to price Over-ride commission Calculate explicitly as discount/load to price Brokerage Calculate explicitly as discount/load to price Classes covered Market data external benchmarks review expected profitability of added/lost underlying business. For the underlying business, changes could include Underlying exposure volumes Assuming price per exposure, apply multiplicative factor Pricing of underlying direct business Page 9

30 Subject SA3 (General Insurance Specialist Applications) September 2005 Examiners Report Depends on how it feeds through if treaty price is % of underlying then multiplicative, if fixed amount then no change. If combination of both then submission needs to be examined Types of business underlying Market data apply external benchmarks to adjust for new/discarded business Policy wordings / exclusions underlying Approximate adjustment qualitative view based on change in terms if removing head of claim (e.g. asbestos exclusion) this may be possible to do more accurately Territories Market data apply external benchmarks to adjust for new/old territories Deductibles Feed from pricing model using increased limit factors to reflect change in risk Exposure measure (e.g. payroll/turnover switch) Approximate adjustment qualitative view of change in underlying price Other issues will include: Look at price as rate per exposure rather than just premium amount Consider expected changes in frequency and severity (claims inflation) Allowance for year on year tax changes Adjustment for investment income depending upon how the product is priced Method Group contracts into broadly homogeneous categories Need to consider materiality want usefully large groups, not every contract Consistency with reserving groups feedback from actuarial control cycle For each contract need to quantify overall change in value to company Use solutions suggested above, or other similar appropriate to calculate impact of T&C changes Request that underwriters record their own estimate of changes at point of underwriting Can calculate alternative index of these changes as a comparison Importance of high level common sense checks Consider changes in total 1st loss rate on line for non-proportional book, for instance Check versus business plan for degree of consistency or otherwise A full statistical model may not be practical given the monthly reporting requirement Data Details of all the above for own treaty from underwriting system Ensure that underwriting system is capturing underlying changes from broker submissions in future Market data may assist in calculating simple impacts e.g. RAA data e.g. Increased Limit Factor tables Page 10

31 Subject SA3 (General Insurance Specialist Applications) September 2005 Examiners Report e.g. Relative performance of direct business in different territories e.g. Market pricing indices for direct business brokers, ABI, Lloyd s etc Assumptions In the absence of information about the underlying business on individual treaties then the market T&C changes are a good guide to average movements. Changes in claim severity (inflation +) Changes in claim frequency (possibly inflation driven on excess of loss) Limitations Indicative answers only because: Data collection may be inadequate Insurance business is volatile price increase is no guarantee of profit increase Assumptions may not hold, especially inflation Heavily reliant on information provided by insureds Indicies by line of business will not reflect client profitability (if there are cross subsidies) Danger of spurious accuracy (ii) Other types of underwriting/claims MI could include: Premium written per month Number of policies written per month Deviations on income v expected by contract Large claims advised Large claim movements in the month Any claim notified against large exposures Top exposures written during month Actual v expected claims development by class Impact on reserving of monthly movements in claims Concentration of risk exposure by territory/class etc Total claims notified by class, territory etc. External market information updates Quotation conversion rate Business by source (iii) Advantages of RPP approach Keeps a client happy strengthens relationship Additional income for company (as policy not previously written) Artificially inflates premium further still book reinstatement premiums as well as additional premium this is because a reinstatement premium protection recovery is a claim on a policy and not a premium refund so there are equal increases in claims and premium produced Page 11

32 Subject SA3 (General Insurance Specialist Applications) September 2005 Examiners Report Profit (net of any additional attritional costs) remains the same with either approach Disadvantages of RPP approach Increases exposure to the same risks for the company which may lead to reinsurance exhaustion May not be authorised strictly not reinsurance no direct insurance contract to protect Second contract cost of issuing lots of contracts where one would do May not be covered under company s outwards reinsurance programme (as not reinsurance) Reinsurance cost may actually increase Company may not have the choice of share of RPP as the policies may be broked separately (iv) RPP cover responds to the same losses as the original policy. Cover also responds in same proportion a half limit loss triggers a half reinstatement. Structure of RPP contract mirrors original too therefore risk cost should follow same proportions. Limit of policy is 250,000 (¼ of original). Theoretical risk premium would be / *250000*0.8=50000 END OF EXAMINERS REPORT Page 12

33 Faculty of Actuaries Institute of Actuaries EXAMINATION 3 April 2006 (am) Subject SA3 General Insurance Specialist Applications 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 both 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. SA3 A2006 Faculty of Actuaries Institute of Actuaries

34 1 Packit is a mutual insurance company incorporated in the UK and owned by importers who are retailers and wholesalers based in the UK. The importers have their goods shipped from around the world by reputable carriers. The carriers choose the most suitable transit methods for the goods by land, sea and air. The importers buy an all risks cargo policy from the point at which they purchase the goods to the point at which they enter their stores and warehouses in the UK. Packit was formed when importers felt that insurance rates were too high, and that they could save significant costs through a mutual. Packit underwrites all proposals prior to writing the business. Although there is no restriction on what goods can be insured, in practice they are exclusively high street non-perishable goods including clothing, electronics and white electrical. Recently there has been a major catastrophic loss at a large distribution hub resulting in losses to warehoused and containerised goods largely as a result of water damage. The size of the loss has exhausted Packit s reinsurance programme resulting in a large net loss. Following this event Packit has asked for a comprehensive review of its operations. You are the consulting actuary advising Packit. (i) State how the various UK tax rules apply to Packit and the policies it sells. [3] (ii) Describe how the current loss should be recovered from the member companies and steps which may be taken to reduce the size of loss. [16] (iii) (a) State the desirable characteristics of rating factors. (b) (c) (d) List the main risk factors which are likely to be used for rating this type of business. Describe why your chosen factors are likely to be the main factors. Explain why some of your risk factors will not be used as rating factors. [14] (iv) (v) Describe the different ways in which differing policy deductibles and limits requested by the different members could be priced equitably. [4] Describe the considerations that Packit needs to evaluate when designing next year s reinsurance programme. [12] Based on recent studies you have found that the expected cost of claims to Packit is a function of the maximum sum at risk and the selected attachment point. The percentage of claim cost below the attachment point = * (attachment point * 100 / maximum sum at risk) 0.2. SA3 A2006 2

35 You are pricing a quote. The importer wants to reduce its insurance cost and thinks that a total loss is unlikely. It has therefore asked for a policy which protects it for 40% in excess of 10% of its maximum exposed values. (vi) (a) Calculate the percentage of claim cost retained by the importer. (b) Comment on the suitability of the importer s policy request. [9] [Total 58] 2 Payfast is a general insurance company writing only payment protection insurance. Payment protection insurance protects a borrower s ability to maintain loan repayments should he/she be unable to keep up his/her repayments due to accident, sickness or unemployment. Payfast writes its business through retailers selling furniture and electrical goods via various credit schemes. For each payment protection plan taken out, the customer pays a one-off premium, typically about 10% of the amount borrowed. In return the insurer will cover the customer s monthly loan repayments: for the period of the remaining loan term while the customer is hospitalised; and for a maximum of 12 months in the event of unemployment or disability The majority of the payment protection plans cover level monthly repayments. Payfast pays a commission to the retailer of between 30% and 60% of the gross premium paid by the customer. The level of commission varies by retailer. The terms of the credit schemes generally range from 3 to 5 years. Payfast s earned premiums are based on the assumption that risk reduces uniformly during the term of the payment protection policy. Premiums earned in 2005 totalled 11.3m gross of commission. The company has been writing business since 1 January Paid claims have totalled approximately 3%, 5% and 10% of gross earned premium in 2003, 2004 and 2005 respectively. Payfast currently books an outstanding claims, IBNR and claims handling expense reserve of 2.0m as at 31 December It has shareholders funds of 20.0m at that date. From your market research you have established that: a current expected ultimate loss ratio for an account of this nature is 20%, gross of commission IBNR claims at the end of an accident year are typically equal to 25% of the ultimate claims for that year claims handling expenses are typically 20% of claims payments; and it is common for payment protection insurers not to establish case estimates SA3 A PLEASE TURN OVER

36 (i) (ii) Describe the risks relating to premiums and claims that are faced by Payfast. [5] Suggest steps that Payfast could take when underwriting the business in order to mitigate some of these risks. [6] (iii) (a) Suggest the factors that would influence the earning pattern for each individual policy. (b) Comment on Payfast s assumption that risk reduces uniformly during the term of each individual policy. [7] (iv) (v) (vi) Describe how you would segregate Payfast s claims and policy data for the purposes of monitoring profitability. [6] Comment on the reasonableness of Payfast s outstanding claims, IBNR and claims handling expense reserve of 2.0m as at 31 December [10] Suggest, with approximate calculations, how you might expect Payfast s shareholders funds to change between 31 December 2005 and 31 December 2006 assuming that the company stopped writing business on 31 December [8] [Total 42] END OF PAPER SA3 A2006 4

37 Faculty of Actuaries Institute of Actuaries EXAMINATION April 2006 Subject SA3 General Insurance Specialist Applications EXAMINERS REPORT Introduction The attached subject report has been written by the Principal Examiner with the aim of helping candidates. The questions and comments are based around Core Reading as the interpretation of the syllabus to which the examiners are working. They have however given credit for any alternative approach or interpretation which they consider to be reasonable. M Flaherty Chairman of the Board of Examiners June 2006 Comments Individual comments are shown after each part question. Faculty of Actuaries Institute of Actuaries

38 Subject SA3 (General Insurance Specialist Applications) April 2006 Examiners Report 1 (i) Underwriting losses and profits are regarded as arising from mutual trading and hence are exempt from tax. The investment return is taxed independently. The return from loan relationships will be taxed as income on a mark-tomarket basis, unless accounts used amortised cost. However, with respect to equities, realised investment gains are subject to capital gains rules and hence indexation relief applies. No relief is given for expenses, which are assumed to be part of the mutual trade. VAT is not payable on insurance premiums Insurance for commercial ships and aircraft, commercial goods in international transit and risks located outside the UK are exempt from IPT. Comments on question 1(i): Generally well answered although many candidates did not realise it is the mutual trading which is the reason for no taxes on profit and also many got IPT wrong. (ii) The rules may define what happens in these circumstances and therefore leave little scope for flexibility. The rules of the mutual must be followed. There may be a request for a special premium (effectively a capital injection) or an explicit capital injection. This may require that any special premium be calculated in proportion to the capital provided, or to the insurance premiums paid in the last year. If the loss is recovered by higher premiums in future then this may be by adding a larger profit margin (percentage) to the premiums charged. Or by explicitly adding an amount in respect of the loss. The insurance premiums charged should take account of the post loss commercial premiums. The mutual may have the opportunity to recover its losses through higher premiums whilst still offering good value to the members. If the mutual were to charge much more than commercially available then member companies would have a good incentive to purchase elsewhere although financial obligations to the losses would remain. In the long run this may result in the mutual being wound up. Page 2

39 Subject SA3 (General Insurance Specialist Applications) April 2006 Examiners Report Some of the goods may be salvaged This is the only realistic way of mitigating the loss Clothing can be washed, ironed and re-packed. None of the electrical or electronic goods will have been powered when the water damage occurred and so some may be recoverable. Water damaged goods could be moved quickly and dried quickly to avoid additional damage being caused. Retail packaging and instructions would be seriously damaged and would need replacing. These steps may be quite costly and require using specialist companies but could significantly reduce the size of the gross loss. As the loss has exhausted the RI programme any reduction in gross loss will be beneficial to the mutual. Once the gross loss is within the RI programme then the benefit to the mutual will be a percentage of the gross saving. The mutual will save on its payment of reinstatement premiums or, if it retained some of the programme then it will save on this portion. The remaining benefit will be taken by the reinsurers. Even so the mutual should benefit in the cost of future reinsurance, as the current loss will be reduced, and therefore have a smaller impact on future pricing calculations. This salvage is likely to be part of the reinsurance terms and conditions and therefore something that the reinsurer insists upon. Secondary ways of mitigating the loss size include being tough on claims. However, as a mutual the aims of the insurer are slightly different and this may be more difficult to do than with a proprietary insurer. E.g. if a member company had not paid its premiums, it may be difficult to void the coverage. (Non-payment of premium is not a valid reason for voiding a claim under English law.) Policies may be voided if specified policy warranties have been breached or policy exclusions may reduce the insured loss. Investigate precise cause of incident seek to offset costs initiate proceedings against culpable parties (candidates should be clear that this is not Packit s property policies but warehouse owners whose policies may pay) Page 3

40 Subject SA3 (General Insurance Specialist Applications) April 2006 Examiners Report Investigate T&C of existing reinsurance coverage and ensure that all possible recoveries under all policy sections are made. A claim may be reduced due to under-declaration of values (similar to averaging; although this is unlikely) The claim may be recovered out of capital or other assets set aside for this purpose. Investigate potential Govt/State disaster compensation. Comments on question 1(ii): Many candidates did not mention that there would be rules governing the operation of the mutual. These rules must be followed. Many candidates however suggested sensible approaches. Salvage was mentioned in passing but given the line of business and the nature of the loss far more should have been said. A couple of different examples would have shown that the candidate understood the problem and was tailoring his solution. This was especially important given the number of marks for this part of the question. Little mention was made of the fact that the claim had exhausted the reinsurance, and the financial impact this would have on the mutual if the gross loss could be reduced. (iii) (a) Rating factors should define the risk, i.e. be a proxy for the risk factor not correlate too closely with other rating factors and that they are practical (simple) Objective Easily measurable. Acceptable to the policyholder Verifiable (desirable but not essential) (b) & (c) Each additional rating factor should, therefore, be chosen to remove as much of the residual heterogeneity as possible. This approach should also help to avoid having too many rating factors and so cause practical problems due to lack of data for analysis of each cell. With respect to the importers the loss frequency and severity will be affected by the type of goods: clothing, electronic or white goods. These may even be subdivided into smaller sub-categories. All these goods are subject to the same major perils: fire, water damage, theft and physical damage due to impact or crushing. Page 4

41 Subject SA3 (General Insurance Specialist Applications) April 2006 Examiners Report Different goods behave differently to these different perils and so the severity of loss by type and peril will be different. Commodity / Peril example 1 mobile phones will be more likely to be stolen than washing machines or Clothing will be much less susceptible to impact and crushing damage. Commodity / Peril example 2 TVs may be more combustible than cotton jeans or Dried foodstuffs will be very susceptible to water damage. Country of origin. Whether the transport is primarily by air or sea. Rating factor example 1 Air crashes are much less common than ships sinking so the frequency of loss will be lower for air freight. Or Airports tend to be subject to higher levels of security than sea ports and so theft risk will be lower. Rating factor example 2 But, given a loss an aircraft will be more likely to suffer total loss so severity higher. The Shipping Company may be used as a risk/ rating factor if this is known. The total value of goods at risk in the year. This is a measure of the exposure to the policy and is a proxy for the number of transits which take place. The maximum single sum at risk is another exposure measure and defines the largest loss which could occur. A larger sum at risk has the possibility of a larger loss than a smaller sum at risk. The amount of policy deductible. For a given set of circumstances a higher policy deductible will give rise to a smaller claim size than a smaller deductible. The points of largest risk will probably be during loading and unloading. Once an item is on a ship or aircraft the theft and damage risks are small, so distance travelled is likely to have a smallish effect. (Distance could be a rating factor as it has an impact on risk and may be a proxy for the number of trans-shipments). Page 5

42 Subject SA3 (General Insurance Specialist Applications) April 2006 Examiners Report The number of times a cargo is moved between storage and a method of transport will be an important risk factor but is not a practical rating factor. It is almost impossible to determine in advance. The Shipping Company may not be used as a risk / rating factor if this is unknown. The security of the transit locations could be important but very difficult to measure as the goods owners will have little say in the transit route, that being controlled by the shippers. So not a practical rating factor. Comments on question 1(iii): The bookwork part of this section was well answered but the application and higher skills parts were poor. (iv) Policy limits and deductibles will be best dealt with by either an exposure measure or a frequency / severity model. Exposure based methods would be either an exposure curve or increased limit factors. Exposure curves describe the claim severity distribution: this could be a loss size distribution or may express the deductible as a percentage of the sum insured (i.e. first loss curves) This claim size or percentage can then be read from the curve to give the proportion of claims cost which is retained within the deductible. Increased limit factors work in a similar way but the limit and deductible are looked up as factors. The factors at these amounts are then used to calculate the proportion of claim cost retained by the deductible. (Mention of Limited Expected Values score here.) There may be more than one claim distribution needed to fully describe the observed claims and therefore to calculate the equitable portion of claims within the deductible. Experience methods on observed historic claims for the cedant can be used but are unlikely to give equitable answers as the observed claims are unlikely to be a good representation of all the possible claims outcomes. (Burning cost methods do not score as being equitable.) Comments on question 1(iv): This question was exploring the higher skills and wider reading of candidates. Candidates generally scored low marks on this section with very few referring to exposure based methods (either exposure curves or increased limit factors) or frequency/severity models. Page 6

43 Subject SA3 (General Insurance Specialist Applications) April 2006 Examiners Report (v) Considerations: Cost of cover following a large cat loss the cost of RI is likely to go up following the exhaustion of the RI programme the cost will go up even for high layers which were not purchased previously can the mutual afford to buy the RI it would like to? can the mutual afford not to buy and run the risk net? Expected recoveries linked to the cost, the mutual will want value for money these will be evaluated by amount using both frequency and severity May need to reparameterise frequency severity distributions following the experienced losses for accurate analysis. Alternatives to traditional reinsurance development covers etc. ART, financial assistance, loss Availability of cover what cover is available following the cat in terms of capacity (amount) capacity may be severely restricted following a large cat and in terms of coverage Likelihood of a similar event if the last event was seen as a remote event e.g. 1/10,000 years then the mutual may not want to buy the cover this will be location and peril specific Exhaustion of the current programme Vertical exhaustion by how much? wanting to ensure that a future loss does not exhaust the programme Sideways cover The number of reinstatements needed for multiple events in the same policy period. Level of exposure for the following year sums insured Maximum accumulations of value next year per location and geographically although this may be hard to determine when the mutual has little knowledge of the shipping details Risk appetites of the member companies more risk averse will want to buy more protection or vice versa Rating agencies security status/rating of available reinsurers Page 7

44 Subject SA3 (General Insurance Specialist Applications) April 2006 Examiners Report Diversification of reinsurers (reciprocity does not apply for a mutual) Relationships with reinsurers Advice through purchasing reinsurance (most likely the advice will come from the broker) Reinsurance used by other mutuals (e.g. cover for a group of mutuals) Regulatory requirements Amount of capital free reserves - could raise loan capital & reduce the need for RI Comments on question 1(v): Many candidates failed to pick up marks by not exploring a wide enough range of options. (vi) Percentage of claims cost below deductible = 39.81*(10% *100) 0.2 Percentage = Percentage of claims cost below the limit = 39.81*(50%*100) 0.2 Percentage = So the percentage retained is the deductible = Plus the proportion above the limit = = Giving a total retained percentage of loss = 76.04% It is unlikely that the importer would really want to retain this much of the risk. As the shareholders of the component companies will want a steady trading profit from its core business rather than an uncertain profit driven by claims which could be insured. Even a 1% of maximum value deductible would result in nearly 40% of the claim cost being retained. (Or similar calculation.) The claims distribution is therefore very heavily weighted towards smaller claims. Only insuring up to 50% of the maximum value without deductible means that 87% of the claim cost is covered. (Or similar calculation.) This is a high proportion of the total claim cost and could be justified. It depends how frequent large losses are. If they are very infrequent and the financial implications have been evaluated then the importer may feel that it is worth the risk. Even though the premium is higher than the expected claims due to expenses the cover provided may be very beneficial to the importer due to the reduction in volatility. Page 8

45 Subject SA3 (General Insurance Specialist Applications) April 2006 Examiners Report If the mutual is inefficient, or another insurance company takes a different view of risk then the insurance cost may be high and cheaper cover may be available elsewhere. Comments on question 1(vi): Most candidates scored well on the calculation, although disappointingly a number failed to perform this simple task. A common error was to misinterpret the 40% in excess of 10% layer as 40% of an unlimited excess of 10% layer. Conclusions were not well drawn. Candidates often did not notice that this loss distribution was very heavily weighted to smaller claims or that the very high proportion of retained claim cost is likely to be unsuitable for an importing company. 2 (i) Risks relating to premiums Policy is longer than annual in that premium charged at start of policy has to cover risk of accident, sickness or unemployment over 3 to 5 year period so harder to get premium rating right. And Payit is a new company so the lack of data is especially problematic. Downturn in economic environment.sales of goods reduce hence volumes of payment protection insurance business reduce. Change in retailers sales procedures may lead to loosening of underwriting conditions e.g. more selection/moral hazard: policyholders expecting unemployment or deliberately becoming unemployed. Retailers may take their business elsewhere or demand higher commission or not sell enough policies. Credit risk with failure of retailers to return premiums. Greater scrutiny by regulators of levels of commission being charged => potential damage to reputation, reduction in market size as customers choose not to insure themselves. Page 9

46 Subject SA3 (General Insurance Specialist Applications) April 2006 Examiners Report Risks relating to claims Unexpected downturn in economic environment..leading to higher than expected unemployment rates. Increases in morbidity experience Pandemic Propensity to claim Reputational risk (media) may mean paying claims that you would otherwise have excluded Policy wordings not holding up in court e.g. unfair policy exclusions. Comments on question 2(i): This largely bookwork question was answered fairly well. A common shortfall was to simply say that moral hazard, or the economy were risks. It is an unexpectedly high level of moral hazard, or an unexpected downturn in the economy which are risks. (ii) Establish agreed sales procedures with retailers. A void accumulations by retailer and or region. Introduce profit commission terms to encourage retailers not to underwrite poor risks. Using the information gathered for credit scoring etc. Demographic information of retailer impacting sickness --- driving premium rates by store and region Implement exclusions in policy wordings Examples: - Deliberate or wilful acts of self-injury. - Pre-existing conditions. - Acts which result in self injury for example drinking alcohol or drug abuse. - Any mental or nervous conditions unless under the supervision of a psychiatrist. - Backache or related conditions without medical certification. - Unemployment within the initial exclusion period. - Voluntary unemployment. - Unemployment known before the start of the policy. - Casual, seasonal or temporary employment. - No payment for any period where policyholder is paid salary in lieu of notice. - Loss of job through any fault of policyholder s. - Or any other sensible exclusion e.g. waiting period. Page 10

47 Subject SA3 (General Insurance Specialist Applications) April 2006 Examiners Report Or refer special cases to insurer for underwriting. Comments on question 2(ii): Most candidates got the basic ideas here but did not adequately elaborate on the policy exclusions which are so important to this policy (iii) Nature of loan payments: If level, then the outstanding repayment amount reduces uniformly with each payment hence risk reduces uniformly during the term of the loan.. Nature of loan payments: If not level, (e.g. no repayments for a year or low start repayments rising later ) Then the outstanding repayment amount does not reduce uniformly and hence the risk does not reduce uniformly during the term of the loan Insurance terms: period over which payments will be made (e.g. nothing to pay for the first year) ; are there limits? Waiting period? Term of policies. Morbidity rates rise as people age. Or Gender Or Age or Occupation. Changes in state of the economy. If underwriting is applied at the time of sale the risk will be lower initially Selection: does experience indicate that selection occurs earlier in the policy? Propensity to claim: does this reduce as policy approaches expiry? Unemployment and disability: makes sense to assume closer to level risk profile as payment is limited to 12 months and hence reduction of exposure would only occur in last 12 months of the policy. Comments on question 2(iii): Many candidates did not seem to understand that it was the repayments which were being guaranteed. Loans on this type of purchase are normally by level repayment which does not change with the interest rate. In this case the outstanding repayments and therefore risk reduce uniformly through the policy term. Unemployment and disability pose a level risk for the majority of the policy term. Identification of these key features allowed some candidates to score well but many candidates did not seem to understand risk exposure. (iv) Monitor on monthly basis because company has only been writing for a few years. Segregate the policies by retailer as different commission levels. Segregate by country or region Split by any extra rating factor gathered at point of sale. Page 11

48 Subject SA3 (General Insurance Specialist Applications) April 2006 Examiners Report Segregate policies by size of loan or type of credit scheme as some may encourage more selection/moral hazard than others. Analyse by policy term to estimate claims development and earnings pattern. Analyse sickness, accident and unemployment separately. Compile accident year triangles of paid loss ratios to monitor profitability on earned basis. Compile underwriting year triangles of paid loss ratios to monitor profitability on ultimate basis. Comments on question 2(iv): Generally answered well. (v) Company s outstanding claims reserve is likely to be about 80% of the 2m claims and expense reserve => 1.6m. This represents 14.2% of earned premium gross of commission. Plus 10% paid loss ratio gives 24.2% ultimate: higher than market loss ratio of 20% It is not entirely clear whether the IBNR contains allowance for the claim handling expense. If not then the claims handling reserve will also need to be added & will make the ULR higher still. Paid loss ratio in 2005 was 10%; allowing for 25% IBNR => chain ladder ULR of 10% / 0.75 = 13.3%. This is less than market loss ratio of 20%. Company s outstanding claims reserve is higher than predicted by chain ladder and by market average. However market loss ratio may be based on portfolios with very different commission levels. Portfolio likely to be less mature than market average with higher IBNR as percentage of ultimate. Plus actual experience may be poor guide to IBNR. Note than paid loss ratios have been increasing, which may suggest that earning pattern is inappropriate i.e. perhaps earning premium too fast. Lot of uncertainty because insufficient history on which to base projections. Page 12

49 Subject SA3 (General Insurance Specialist Applications) April 2006 Examiners Report On the available information it is difficult to comment on the reasonableness of the outstanding claims reserve. However as Payfast is estimating a ULR approximately 20% worse than the market it suggests that they are not being unduly optimistic. Comments on question 2(v): Most candidates used the market loss ratio as their starting point. Very few candidates performed an independent calculation and then used this as a basis for comparison to the market. Any reasonable comparison scored well. (vi) No profits from new business. Assuming commission of 50%, say, and claims (+ claims handling expense) loss ratio of 20% => 30% profit (before other expenses) on earned premium. Premium earned in 2006 likely to be lower than that earned in 2005 as some of the 3 year policies written in 2003 would earn little in 2006 plus earning pattern reduces with term so assume EP in 2006 is less than half that in 2005 => 5m. Assuming 30% profit, this 5m will earn at least 1.5m of profit which is taxable at say 30% (or any reasonable tax assumption) Thus increasing shareholders funds by about 1m. Any reasonable expenses assumption Assumes no dividends. Any reasonable assumption on investment returns on free assets Also, any reasonable investment assumption on technical provisions Comments on question 2(vi): Many candidates got bogged down in calculating the earned premium in detail and a number of candidates did not make any attempt at this section. A sensible estimate using the understanding of part (iii) was all that was required. The remainder of the calculation was then straightforward. In estimating the profit margin, many candidates forgot to include the commission terms. Given the significant size of these this was a serious error. END OF EXAMINERS REPORT Page 13

50 Faculty of Actuaries Institute of Actuaries EXAMINATION 11 September 2006 (am) Subject SA3 General Insurance Specialist Applications 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 both 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. SA3 S2006 Faculty of Actuaries Institute of Actuaries

51 1 You are the newly appointed actuary for a small UK general insurance company that writes liability insurance through regional UK brokers and Lloyd s. The company is newly established having started writing risks on 1 July The professional indemnity class of business currently accounts for most of the business written by the company. One of your first tasks as the company s actuary is to estimate outstanding claims and IBNR requirements as at 31 December 2005 for the purposes of the company s yearend accounts. The company accounts for its business on a one-year accounting basis. In addition to the company s own detailed policy and claims information, you have decided to obtain benchmark claims development and loss ratio information from publicly available sources. You have collected paid, incurred and ultimate loss ratios by year of account from the UK statutory returns submitted by 10 different insurance companies. You have selected each of the 10 companies because they present a professional indemnity classification within their returns. Having collected these data, you realise that it may not be appropriate to include data relating to all of the 10 companies within your benchmarks. Your company s professional indemnity underwriter has agreed to assist you in identifying those companies whose data should be used for benchmarking purposes. (i) (ii) Suggest two main reasons why UK statutory returns are more useful than Companies Act accounts for deriving reserving benchmarks for your company. [2] Explain the distinguishing aspects of each professional indemnity account that you would wish to investigate when selecting the most appropriate loss ratio benchmarks for reserving purposes. [18] Following your discussions with the professional indemnity underwriter, you have made your informed selection from the 10 benchmark accounts and you have combined the information, weighted by volumes of business, to produce the following summary table. Accident 2002 Returns 2003 Returns 2004 Returns Year PLR ILR ULR PLR ILR ULR PLR ILR ULR % 88% 125% 43% 105% 123% 85% 118% 122% % 36% 91% 21% 64% 85% 38% 76% 86% % 29% 70% 23% 46% 65% % 23% 60% Notes to table: 1. PLR = paid loss ratio = paid claims at valuation date divided by earned premium at valuation date 2. ILR = incurred loss ratio = incurred claims at valuation date divided by earned premium at valuation date 3. ULR = ultimate loss ratio at valuation date SA3 S2006 2

52 The underwriter has additionally provided you with his estimates of market premium rate changes over the past 3 years and these are shown in the table below. Underwriting Years Premium Rate Change % % % % (iii) Describe how you might use the information provided in the tables above to estimate a benchmark ultimate loss ratio for the 2005 accident year, stating additional information that you might require from the underwriter. [14] (iv) (a) Estimate average paid and incurred claims cumulative development percentages for an accident year at the end of the first, second, third and fourth development years. (b) Comment briefly on the reliability of your results. [10] (v) Suggest, with reasons, the extent to which you would expect to use your company s own claims data versus benchmark information for reserve reviews as at 31 December 2005 and 31 December [14] [Total 58] 2 You are an actuary working for a large UK general insurance company. A motor manufacturer has approached your company to underwrite a new scheme that provides gap insurance cover to purchasers of new vehicles sold by its network of dealers. Under the terms of this policy, the insurance company will pay out the difference between the original purchase price and the amount paid out by the insured s own private car insurance policy in all events of the vehicle being written off. The insurance cover is for the first three years of vehicle ownership, provided the vehicle remains under the ownership of the original vehicle purchaser. The manufacturer has expressed a preference that all purchasers of vehicles in the UK pay the same flat monthly premium for the cover. The premium will be payable for a period of 12 months from vehicle purchase. (i) (ii) (iii) (iv) Discuss the advantages and disadvantages to the new vehicle purchaser of this policy. [6] Describe risks that are likely to exist in this scheme for the insurer, suggesting ways in which these risks can be mitigated. [16] Discuss the data you will require to calculate the risk premium, including possible sources for this information. [14] State the other data or information you would consider in deciding whether or not to underwrite the scheme. [6] [Total 42] END OF PAPER SA3 S2006 3

53 Faculty of Actuaries Institute of Actuaries EXAMINATION September 2006 Subject SA3 General Insurance Specialist Applications EXAMINERS REPORT Introduction The attached subject report has been written by the Principal Examiner with the aim of helping candidates. The questions and comments are based around Core Reading as the interpretation of the syllabus to which the examiners are working. They have however given credit for any alternative approach or interpretation which they consider to be reasonable. M Stocker Chairman of the Board of Examiners November 2006 Comments Individual comments are shown after each part question. Faculty of Actuaries Institute of Actuaries

54 Subject SA3 (General Insurance Specialist Applications) September 2006 Examiners Report 1 (i) Companies Act accounts do not show results by class of business whereas UK statutory returns show results by class and risk group. Companies Act accounts show figures by revenue year whereas statutory returns are divided by underwriting year or accident year. These points are contained within the core reading, although surprisingly few candidates gained full marks on this bookwork question. A number of candidates made incorrect comments on the different levels of prudence within the outstanding claims and IBNR reserves between the accounts and the returns. (ii) Mix of business by profession The ultimate loss ratios ( ULR s ) may differ between, for example, solicitors, architects, brokers, actuaries, accountants, IFAs. This may be due to different levels of competition in these different sectors due to different levels of risk appetite e.g. IFA professional indemnity experience has been poor in recent years due to pensions mis-selling. Some insurers may concentrate on only one profession.e.g. writing solicitors business through a lineslip. And others may exclude certain professions.e.g. no big-4 accountancy firms. Some professions may incept at certain times of the year e.g. solicitors business incepting in September/October which is particularly relevant to consider for a company that has only been writing since 1 July. Size (turnover or number of partners) of assureds Large practices may have very different claims experience to smaller practices, Which is particularly true for sole practitioners. Large practices usually have higher fees and larger potential losses. Different size assureds are likely to have different risk management standards. Different assureds have different clients and therefore different services are provided (some are more risky). Territory in which business written Lloyd s business may be different in nature to UK regional e.g. due to size of risks. Lloyd s business may include non-uk risks. US professional indemnity business in particular may perform differently to UK (e.g. due to litigation). Currency issues need to be considered. Source of business Different coverages or exclusions Page 2

55 Subject SA3 (General Insurance Specialist Applications) September 2006 Examiners Report Size and type of lines written Some insurers may write mainly primary layers whereas others write excess layers. Limits and deductible may differ. Claims made vs claims occurring policy Business written on a claims made basis may be different in nature to that written on a claim occurring basis e.g. volatility of ULRs due to dependency on legislative changes. Different underwriting philosophy Some insurers trying to build market share may be happier to write at a higher loss ratio. Underwriter may have views on quality of underwriting done by competitors. Different rate change history Different reserving philosophy Drivers for different reserving strengths may be different case reserving practices/philosophies. Some companies ultimates may show a systematic downwards trend in ULRs over time for a given year of account. Underwriting year vs Accident Year If written on a funded basis, business will appear in statutory returns classified by underwriting year. If written on a one-year basis, business will appear in statutory returns classified by accident year. We would prefer to use accident year benchmarks as this is consistent with company s one year accounting. Although 2005 accident year ULRs could perhaps be estimated by averaging 2004 and 2005 underwriting year ULRs. Impact of exceptional/large claims that the underwriter would know about. Size of account Size of account impacts credibility for benchmarking purposes. Smaller accounts may be more volatile in terms of claims experience. Maturity of account A growing account may have different characteristics to a stable one. New accounts are likely to have less historical data on which to base ULR projections that more established accounts. This question was reasonably well answered, with candidates able to generate a wide range of points. The stronger candidates were able to tailor their answer to give Professional Indemnity specific points. Some candidates appeared to be unrealistic about the information that they would expect the Page 3

56 Subject SA3 (General Insurance Specialist Applications) September 2006 Examiners Report company actuary and/or underwriter to know about the benchmark companies. The question asked about benchmarking for loss ratios and not for development patterns, although some answers focused on the impact on the latter. Most candidates did not explain why different claims characteristics for different professions would automatically mean different ultimate loss ratios. (iii) Starting point is to make a choice about which base years to use. Professional indemnity is reasonably long-tailed so that would lead us to place less reliance on ULR s on immature years. At the end of the first development year, the incurred claims seem only to be about 40% of ultimate claims. So suggest not relying too heavily on 2004 booked ultimate loss ratio. Historically, it can be seen that the ULR for a particular accident year can drift over time. It may be that companies book a pessimistic ULR initially to avoid poor run-off. For example, the 2002 accident year ULR has reduced over time may be too old to be representative [the examiners accepted other sensible comments about the reducing relevance of older years] terms and conditions are likely to have changed alongside the premium rate changes and there may have been a shift in the mix of business with new capacity entering the market. Establish from underwriter whether there are any large losses/events that might have distorted any of the figures in the market information. May use 2002 and/or 2003 accident years as starting points. [or other sensible conclusion] Roll forward for premium rate changes Definitely need to adjust for rate changes as they haven t been flat and will therefore have a big impact. Need to understand from underwriter more about what the premium rate change information represents:.before or after allowing for claims inflation?.and what would a typical claims inflation assumption be?.before or after allowing for exposure (e.g. assured fees) inflation?.has allowance for changes in terms and conditions e.g. reduced coverage been made in the rate change information? One approach is to estimate the earned premium rate change between year x and x + 1 as the average of the underwriting year rate changes between x -1 and x + 1. Although we would need to discuss with underwriter how business incepts and earns throughout the year. We may need to make an adjustment for changes in the environment, target market, longer term trends e.g. legislation, impact of the insurance cycle etc Page 4

57 Subject SA3 (General Insurance Specialist Applications) September 2006 Examiners Report The table below is an example of how the ULR s shown in the 2004 returns may be rolled forward to 2005 terms, assuming premium rate changes include exposure inflation. Earned Rate Change From Previous Year ULR in 2005 Terms Accident Years Starting ULR Inflation Assumption % NA 8% 65% % 38% 8% 63% % 18% 8% 63% % 8% This uses the most recent ULR s (from the 2004 returns) although these may be prudent for the more recent accident years A sensible claims inflation assumption might be e.g. 5% to 10%. Select the average of the 2002 and 2003 ULRs => 64% as 2004 too immature to rely on 2004 ULR at this stage (or other sensible selection and justification). We would need to understand the treatment of commission: is premium gross or net of commission in the statutory returns? There was a wide variation in the quality of answers for this question. Although the question did not specifically ask for ULR calculations, the best descriptions were those that used the data provided in the question; this enabled students to demonstrate the various steps required more clearly. Some candidates appeared not to have learnt from recent SA3 questions on calculating ULR s. This is worrying given the practical use of this technique and the importance of being able to sense-check loss ratios against the backdrop of information on premium rate changes and claims inflation. Good candidates were able to use the claims development information provided in the question in order to make a judgement about which base years to use. Some candidates went further than this part question intended and tried to estimate the effect on the loss ratio of the company having only written business since 1 July In these cases, the examiners gave some credit accordingly under Q1(v). (iv) Divide PLR by ULR to get sample % developed from data on 2001 to 2004 accident years. Use the ULRs from the same returns as the PLRs in order to avoid distortions from changes in earned premium over time. Average development % s across accident years, shown in the tables below [Note: an alternative approach to the above calculations is to divide the PLR or ILR by the latest estimate of the ULR in each case, rather than the ULR estimated at previous year-ends. This approach assumes that the earned premium in the denominator is consistent over time (i.e. no late bookings or misstatements of premium). This alternative approach was given full credit by the examiners only if that assumption was stated.] Page 5

58 Subject SA3 (General Insurance Specialist Applications) September 2006 Examiners Report Paid cumulative development percentages Accident Development Year Year % 35.0% 69.7% % 24.7% 44.2% % 35.4% % Average: 6.3% 25.6% 39.6% 69.7% Incurred cumulative development percentages Accident Development Year Year % 85.4% 96.7% % 75.3% 88.4% % 70.8% % Average: 39.8% 72.2% 86.9% 96.7% Comments on reliability of results Development year 4 position is based on only one sample point (relating to 2001) so this is likely to be less reliable. For incurred claims, there seems to be a reasonable amount of consistency between sample points at the same development period => reliable. For paid claims, there appears to be some evidence of claims speeding up: for second development year, % developed goes up from 16.8% on 2001 accident year to 24.7% on 2002 and 35.4% on for third developments year, % developed goes up from 35.0% on 2001 accident year to 44.2% on Using averages won t reflect any such trends. May prefer to use incurred patterns rather than paid patterns (especially as incurred is more mature). However incurred claim development percentages depend on consistency of case estimate strength. The existence of the tail factor in the projections increases uncertainty. The numerical parts of this question were not very difficult and a lot of marks were available for good quality comments on the results. There were many candidates, however, who failed to gain many marks on the numerical parts or who were not able to make observations on key features of the development Page 6

59 Subject SA3 (General Insurance Specialist Applications) September 2006 Examiners Report patterns. Some candidates tried to adjust the data for premium rate changes, which was unnecessary. Some candidates gave development of loss ratios which was not requested. (v) Generally One key factor is speed with which claims are expected to develop. Would expect to move gradually from benchmarks to company s own data as time goes on. Perhaps using a Bornhuetter-Ferguson type of approach. Likely to rely on incurred claims data before paid as paid will be too immature initially. Depends on confidence in own case estimation. Unlikely to rely on paid chain ladder for the first three development years as less than 40% developed. Benchmark claim development patterns suggest that incurred claims are reasonably mature by the end of the second development year and hence it likely that at least some reliance would be placed on chain ladder from this point. Likely to recognise differences between company and market experience earlier if company experience appears worse than market s. Would also treat very large losses separately. As at 31 December 2005 Only need to calculate IBNR in respect of 2005 accident year. May want to calculate 2006 ULR to check UPR is sufficient to cover unexpired risk is not a typical accident year as business only written from 1 July even if business written evenly between 1 July and 31 December, earnings will not be even over the second half of therefore average accident date likely to be biased towards November rather than mid-year. Our 2005 accident year is even less mature own claims experience multiplied by market development factors will underestimate ultimate. Even if use Bornhuetter-Ferguson, far bigger weighting would go to independent (market) ultimate loss ratio than to chain ladder. So rely heavily on market ultimate loss ratio as claims to date of little use (except if the account suffers large losses or very bad experience). As at 31 December accident year will still not have an even earning pattern as missing accidents relating to business written in the first half of 2005.plus likely that business volumes still increasing over 2006 as company establishes itself Therefore average accident date is likely to be biased towards second half of year. And it will not be easy to compare actual claims developments on 2005 and 2006 accident years with those from the benchmark data. Page 7

60 Subject SA3 (General Insurance Specialist Applications) September 2006 Examiners Report So likely to give significant weight to market loss ratio on both accident years. The strongest candidates understood that both the accident years would be more immature than a typical accident year because no policies were written in the first half of the first underwriting year. A number of candidates talked at length about the validity of benchmarks but did not appreciate that there was little alternative but to rely on them. 2 (i) Advantages: When an accident involving a total loss of the vehicle occurs, road risk insurance companies will usually pay out the actual value of the vehicle. This will usually be considerably less than the original purchase price of the vehicle due to market value depreciation within the UK motor sales market. Depreciation of the vehicle market value will be particularly steep in the first three years of a vehicle s life before slowing down thereafter. Vehicle purchasers will have financial peace of mind in the knowledge that they will be covered in the event of accidents where they were not to blame or driving at the time (e.g. theft of the vehicle) or involved complete or irreparable damage to the vehicle (e.g. fire, total write-off of vehicle in a road accident). Road risk car insurers will not take into consideration any outstanding loan on the vehicle purchase. Holding gap insurance cover will assist the policyholder in paying off any outstanding amount of the loan rather than be in a position of negative equity. The policy will pay out in full if the vehicle is written off by an untraced driver or failure to pay by the owner s insurance cover for another reason. If the cover is free then this is good for the purchaser, but the cost may already be included in the cost of the vehicle. Premiums are known in advance in terms of level and period of payment so will assist in financial planning (or could be regarded as an additional monthly element to budget for in addition to road risk premium and loan repayment). No need to argue with the motor insurer on the value of the car. Disadvantages: The rates charged for gap insurance are often high. The cover may be of limited use to a car purchaser who changes his car frequently, e.g. once a year. Value depends on risk appetite of car purchaser: he may not wish to pay for something considered unlikely. No benefit is provided if there is a bad accident but the car is not written off. The customer may not want to pay three years cover in the first year. There is no value in the first year if the motor insurer gives new for old cover in the first year Page 8

61 Subject SA3 (General Insurance Specialist Applications) September 2006 Examiners Report The amount recovered in total from the gap policy and private car insurance would not be sufficient to replace the car with an equivalent new model due to price inflation. This question was well answered by many candidates. (ii) Risks and mitigants The main risk is that the premium rates charged under-estimate the risk. This is a particular problem here as the premium assumptions are based on information which is difficult to get..and the premium needs to cover 3 years of exposure. The lack of rating factors suggests possible anti-selection could occur on this scheme, particularly if the cover is optional. Mitigate by stricter underwriting. For example, different age groups are more/less prone to total vehicle write-off accidental damage claims so should be charged more than those age groups which are have a lower total loss frequency. Similarly different makes of vehicle have different depreciation levels resulting in very different claim severity. Similarly theft claim frequency is very different by postcode so possibly more likely to pick up business only in areas where there is a higher theft frequency. Is the location of the network of dealers biased towards high theft areas? Claim size and variance of size increases over the three year period of the policy. Depreciation of the vehicle value is also based on mileage. The more mileage driven, the lower the market value and hence lower settlement from road risk insurer. Mitigate by having more sophisticated rating structure with rating factors similar to those used in road risk insurance and have the manufacturer pay the theoretical premiums. Monitor frequencies and severities and adjust future premiums as necessary. Potential accumulation of risk with existing motor portfolio where the company insures both the road risk and gap insurance element when a significant event occurs (e.g. localised flood involving write off of many flooded vehicles). Mitigate by aiming for more diverse portfolio in terms of geographical location of road risk and gap insureds. Potential for moral hazard if insured is less likely to look after vehicle knowing that he/she is covered for the full amount of the purchase price for the first three years of the vehicle ownership. Potential for fraud if insured decides to write off vehicle. Risk of not receiving the whole annual premium during the first year of the policy if total loss occurs and policyholder cancels the policy after settlement. or car is resold. Mitigate by collecting premium up front or over fewer months rather than spread over 12 months. Level of new car sales and economic conditions influencing these? Page 9

62 Subject SA3 (General Insurance Specialist Applications) September 2006 Examiners Report The volume of business could be much higher or lower than expected. Too little business might not cover the expenses incurred in writing a new line of business. So part of the agreement might be early cessation of the contract if volumes do not exceed a certain amount to cut losses early. Higher could entail more risk than desired. Mitigate by imposing a pre-determined limit in the contract with the motor manufacturer. Economic conditions impacting on market values of vehicles and therefore severity of claims for gap insurance are leveraged. For example, a 5% increase in depreciation value has a greater than 5% increase in claim severity. Impacts on business plan of a downturn in volumes of business and implications on expenses versus premium income to meet these? Potential failure of vehicle manufacturer and impacts on market values resulting from this. Mitigate by modelling potential scenarios within Business Plan allowing for variation in volumes of business written. In the event of a total loss, the insured has no incentive to dispute the amount paid by his private car insurer as will receive same amount in total whatever amount paid: could mean higher than expected payout from gap insurance. Could mitigate by clause in contract enabling gap insurer to negotiate amounts payable by communication and agreement with private car insurer. Could be moral hazard from underinsurance on car policy (even not comprehensive). Mitigate by clause in gap policy stating that car insurance policy should be comprehensive and car fully insured. The best answers to this question were those that focused on the particular risks of gap insurance. Many candidates did not appreciate the geared impact on claim severity of higher than expected depreciation and therefore did not give enough attention to risk factors impacting market value of the vehicles. (iii) Claims and exposure data are required for both the frequency and severity elements. No historic data exist for this scheme as it is new. Internal motor data could be used to determine possible claims experience on this scheme. Total loss claims frequency for each of the first three years of ownership of a vehicle could be derived from the company s motor experience if there is a reasonable history. This should be split down between theft, total fire/damage and flood if data allows and is credible. Use existing policy data to determine frequencies by rating cell (e.g. by age/gender of customer, location, security features). Page 10

63 Subject SA3 (General Insurance Specialist Applications) September 2006 Examiners Report Consider trends in write off experience e.g. as a result of anti-speeding initiatives or increased security. Claims severity data: need to separate out property damage part of claims. Claims severity data: allow for excesses on motor policy. Severity will be modelled using purchase price and the market value of each type of vehicle. Purchase prices could be obtained from the manufacturer for each vehicle type. This data will need to be projected forward according to purchase price inflation expected in future. Market value by vehicle type likely to be available from Claims department who will have information on expected settlement costs for total losses. Alternatively, industry data may be available (e.g. GLASS) providing information on trade-in prices of second hand vehicles in the motor market as these will be similar to the payout on total loss claims by the road risk insurer. Residual value decay information can also be obtained from published information on the subject. Inflation assumptions required for claims settlement costs of total losses. Look at existing data to determine any trends with vehicle price inflation. Check to see if there have been any historic changes in motor claims handling procedures. Obtain expected sales by vehicle from the manufacturer...and likely customer profiles. Claims handling costs may also be included in the risk premium. Allowance should be made for reduced exposure due to resale of cars within three years, if cover ceases on resale. Allowance may also be made for the probability that not all premiums are received (e.g. if a total loss occurs or car is resold or policyholder dies and the premium payments stop). Or other monthly payment adjustments. Information on resale volumes should be available from company s own or industry data e.g. from DVLA. Some candidates discussed data required for calculating the office premium (e.g. fixed expenses, loading for profit) which gained no credit as this question was specifically on the risk premium. A number of candidates listed a lot of detailed data items, e.g. those used for a standard motor insurance policy, that would not realistically be used in this situation. The stronger candidates were more commercial in their answers, and more realistic about data that would be publicly available. The weaker candidates talked about using the data from other insurers, which showed a lack of commerciality. (iv) Other data when considering whether to underwrite: Likely changes in economic factors that may influence car sales (e.g. price inflation, wageroll inflation, unemployment levels). How long has the motor manufacturer been trading? Existing relationship with manufacturer. Opportunity for cross-sell. Page 11

64 Subject SA3 (General Insurance Specialist Applications) September 2006 Examiners Report Market potential for this kind of business. Insurer s strategy. Market share of manufacturer and credibility in the motor market. Projected future sales by dealer. Geographical spread of sales across the UK. Policy wording and cover conditions to be used. Expected conversion rate of business (policy to car sale ratio)/demand for insurance product. Commission rate payable to motor manufacturer. Expenses of running the scheme split between acquisition, administrative and claims handling costs. Investment return expected on premiums in order to discount. Profit share arrangements. Competitors rates on similar products if available. Any regulations or legislation that may impact on the selling methods for this type of cover. Can the IT systems cope with this product build? Desired return on capital/profit requirements from the scheme. This was a fairly easy question and candidates generally scored well. The best candidates were able to state the other ingredients in the office premium and talk about some of the other commercial considerations. END OF EXAMINERS REPORT Page 12

65 Faculty of Actuaries Institute of Actuaries EXAMINATION 18 April 2007 (am) Subject SA3 General Insurance Specialist Applications 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 both 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. SA3 A2007 Faculty of Actuaries Institute of Actuaries

66 1 You are the reserving actuary at a small UK general insurance company writing just private household buildings and contents insurance. Having joined last year, you have just completed your first review of the latest year-end figures. Your company uses an annual basis of accounting and the latest financial year ended on 31 March You have been asked by the Board to provide your best estimate of the anticipated loss ratio for the year-end accounts and explain the level of uncertainty inherent in your estimate. You are also aware of the following information/facts: Gross Written Premium ( m) Booked Accident Year Loss Ratio Financial year ending 31 March estimate n/a 98% 102% 105% 120% 94% 95% Note: For many years Gross Written Premium has been increasing at 6% per annum. The policy cover was changed significantly on 1 October 2003 as follows, with your predecessor s estimate of the associated expected impact on incurred claims in a typical year on an additive basis shown in brackets: Excess for subsidence claims increased from 500 to 2,500 (15% reduction). New exclusion of subsidence due to defective design / workmanship in the first ten years (15% reduction). Minor additions to cover (5% increase). The various analyses you have undertaken lead you to believe that the underlying trend in incurred claims (after allowing for prior year adjustments) has been rising at an average rate of about 10% per annum, assuming no changes in cover. A heat wave was recorded in August 2003, along with rainfall well below average. July 2006 was the hottest month on record, along with rainfall well below average. Ignoring the effects of any reinsurance: (i) (ii) List the different types of reserves that you might include in your estimate of provisions. [3] Discuss the advantages and disadvantages of reserving on an underwriting year basis. [4] (iii) Define the term loss ratio, giving examples. [3] (iv) Calculate the expected accident year loss ratio for the 2007 financial year, detailing any assumptions you make. [18] SA3 A2007 2

67 (v) Discuss: (a) (b) (c) the extent to which any assumptions you have made may not be valid any potential areas of uncertainty associated with the assumptions in (a), and how you might seek to improve the reliability of the estimates you make by adjusting the assumptions in (a). [10] [Total 38] 2 Megasure Group was established in Japan over 100 years ago. Its headquarters are still in Japan and it has become one of the world s largest general insurance and reinsurance organisations. Although it does not write any business in Europe at present, it has operations in many other countries worldwide. Megasure Group writes most types of insurance and reinsurance business, although not every product is written in every country. Following a strategic review, Megasure Group is considering writing general insurance business in Europe. You are a consulting actuary and have been engaged to advise Megasure Group. You have been told that: It has initially decided to write only commercial property business. However insurance will only be provided on large commercial risks, including large office blocks or factories. Both insurance and reinsurance business will be written. The business will be written in London. Megasure Group is considering two methods of entering the European market: A B Becoming a corporate name on a Lloyd s syndicate writing commercial property business. Establishing a wholly owned subsidiary company in the London market to write this business. Initially they would like advice to help them choose between the two market entry options above. (i) Define the following terms: (a) (b) Lloyd s The London Market [2] (ii) Describe the main features of Lloyd s. [8] SA3 A PLEASE TURN OVER

68 (iii) Describe the main differences between becoming a corporate name on a Lloyd s syndicate and establishing a wholly owned subsidiary. For each difference, explain why it may be important for Megasure Group in deciding its preferred method of entering the market. [12] Megasure Group subsequently decides to establish a wholly owned subsidiary, Megasure Insurance Company Europe (MICE). You have been approached to assist MICE in estimating its capital requirements for regulatory purposes. MICE will start underwriting in You have produced the following estimates for the first three years of operations, based on MICE s business plan: TABLE 1 Estimated Capital Requirements for MICE Amounts in millions Year MCR RMM ECR ICA (iv) State the meaning of each of the abbreviations MCR, RMM, ECR and ICA and give a brief description. Details of how these amounts are calculated are not required. [4] Megasure has considered the amounts shown in Table 1. Megasure needs to transfer capital to MICE in 2007 in order that MICE can obtain approval from the FSA to start writing business in (v) Describe the factors that Megasure should consider when deciding on the initial capitalisation of MICE. Your answer should consider each of MCR, ECR and ICA, in addition to any other relevant factors. [13] In its business plan, MICE assumed it would purchase excess of loss reinsurance and that the net cost of this reinsurance would be 1 million per year. You allowed for this reinsurance when estimating the ICA amounts shown in Table 1. MICE has now asked you to produce an ICA estimate assuming that no reinsurance is purchased. Your revised estimates are shown below, together with the original estimates from Table 1. TABLE 2 Alternative ICA Estimates for MICE Amounts in millions Year ICA if reinsurance is purchased ICA if no reinsurance is purchased (vi) MICE is considering whether it should buy reinsurance or not. Discuss the matters that MICE and its parent, Megasure, should consider. [8] SA3 A2007 4

69 MICE is preparing to submit its authorisation application to the FSA. An FSA official is quoted in the press as saying that London Market insurers must monitor their pricing more closely. MICE has called you to discuss this matter. (vii) List ways in which MICE can make sure it charges adequate premiums, commenting on the practicality of each suggestion. [9] Following authorisation from the FSA, MICE is considering writing another line of business in addition to commercial property. (viii) Discuss the issues that MICE should consider before it decides whether or not to write an additional line of insurance. [6] [Total 62] END OF PAPER SA3 A2007 5

70 Faculty of Actuaries Institute of Actuaries EXAMINATION April 2007 Subject SA3 General Insurance Specialist Applications EXAMINERS REPORT Introduction The attached subject report has been written by the Principal Examiner with the aim of helping candidates. The questions and comments are based around Core Reading as the interpretation of the syllabus to which the examiners are working. They have however given credit for any alternative approach or interpretation which they consider to be reasonable. M A Stocker Chairman of the Board of Examiners June 2007 Comments Individual comments are shown after each part-question. Faculty of Actuaries Institute of Actuaries

71 Subject SA3 (General Insurance Specialist Applications) April 2007 Examiners Report 1 (i) Outstanding reported claims reserve IBNR IBNER Claims handling reserve Reopened claims reserve Catastrophe reserve Equalisation reserve Unearned Premium Reserve Additional Unexpired Risk Reserve Comments on question 1(i): Bookwork generally well answered by most candidates. (ii) Advantages: Avoids heterogeneity arising due to: mix of policy coverage (including terms and conditions) mix of underwriting basis / use of rating factors changes in the mix of business Easier to allocate to underwriting year if date of loss is unclear. IBNR is automatically included in any reserve estimate. URR is automatically included in any reserve estimate. Disadvantages: Takes longer for each year to become fully runoff, giving rise to greater potential uncertainty within the estimates. Does not match the accounting procedures used by the company. Can mask any potential changes in IBNR patterns. Combines periods of potentially different claims environments. May spread the incidence of a catastrophe or major claim event, potentially reducing the apparent magnitude of the event. Comments on question 1(ii): Bookwork with most candidates making a reasonable attempt (iii) Loss ratio: otherwise known as Claim ratio. It is the ratio of the cost of claims to the corresponding premiums. Claim ratios may relate to periods other than a year. e.g. Incurred claims / earned premium for a given accounting year Page 2

72 Subject SA3 (General Insurance Specialist Applications) April 2007 Examiners Report Or estimated ultimate claims / earned premium for a given accounting year. Or incurred claims / written premium for a given underwriting year. Estimated ultimate claims / estimated ultimate premium for a given underwriting year. Incurred claims and earned premiums for a given accounting year should include estimated changes in estimates from prior years. Comments on question 1(iii): Better candidates got full marks. Weaker ones just described one version of the loss ratio. (iv) Assume business is written evenly through the year. Assume that all the policies underwritten are annual. Assume predecessors estimates are correct. Assumption relating to how 6% change in premium applies. Implies earned premium in year to 31 March 2007 = 50m + 50m/1.06 = 97.17m. Assume loss ratio is calculated on an incurred claims / earned premium basis. Implies incurred claims 2001: / = 67.13m, 2002: / = 74.06m, 2003: / = 80.82m, 2004: / = 97.90m, 2005: / = 81.29m, 2006: / 1.06 = 87.09m. Need to assess trend in claims incurred. Up to and including 2003 can be taken at face value as there are no known mitigating factors, other than natural variation. Claims incurred from 2004 onwards need to be adjusted to put them on a constant cover basis. Aside from the change to cover, assume the same levels of exposure are covered each year (that is, assume no other changes). Assume mix of business unchanged following changes in cover. Cover came in half way through 2003/04. Therefore the impact may be assumed to affect 12.5% of claims. Page 3

73 Subject SA3 (General Insurance Specialist Applications) April 2007 Examiners Report However, changes in cover on foundations brought in before the likely influx in claims due to adverse weather conditions, so potential impact of hot summer should be mitigated on a greater percentage of incurred claims. Say 15% (though anything up to, say, 25% may also be considered reasonable). The defined claim event date will be significant. This assumes that the incidence of subsidence claims increased significantly because of the heat wave in August 2003 but after the policy change came into force. Implies claims incurred 2004 would have been (1 / 0.75) = m in the absence of any changes to the cover provided. Likewise, some claims in 2005 will have originated from the original policy wording. So the impact may be assumed to affect 87.5% of claims. However, the heat wave in August 2003 will affect this assumption, with proportionately more claims likely to be affected by the change in cover. Say 95% (though anything from, say, 90% may also be considered reasonable). Implies claims incurred 2005 would have been (1 / 0.75) = m in the absence of any changes to the cover provided. All of 2006 will be on the new cover = (1 / 0.75) = m. Estimates for new claims incurred = average of all years based on constant (old) cover, reduced to new cover basis. However, also need to adjust for higher than average incurred in 2003/04 due to hot, dry summer. By between 15% and 25%, judging by the numbers given say 20% = 0.75 x [ ( / ) ] / 6 = 90.97m. (or alternative sensible calculation based on past results) However, July 2006 was also exceptionally hot and dry so the loss ratio is likely to be markedly higher than the long-run average. However, the effect could be compounded on top of the 2003 conditions, making the impact worse or the impact may be less as many problems will already have been highlighted in 2003/04 and losses will be limited by the changes to cover in So, probably by between 15% and 25% judging by the impact of the conditions in 2003 say 20%. Page 4

74 Subject SA3 (General Insurance Specialist Applications) April 2007 Examiners Report => adjusted estimate for new incurred claims = m 1.2 = m. Expected loss ratio = incurred claims / earned premium = m / 97.17m = As a cross-check seems reasonable given the trend in loss ratios given in the question after suitable adjustments have been made. Comments on question 1(iv): Generally poorly answered. The question required candidates to perform a number of separate calculations and adjustments to historical estimates to obtain a reasonable estimate of the 2007 loss ratio. Candidates who took the time to set out their solution logically tended to identify more of the steps required and so achieve the highest scores. Candidates were asked to detail any assumptions made. Some candidates oversimplified the question by inappropriate choice of assumptions, e.g., assuming that subsidence claims should be ignored, missing the effects of the policy wording or contradicting an assumption that was stated in the question. Many candidates attempted to adjust the 2003 and prior years incurred claims to put them on a constant basis, rather than adjusting the later years. Although it is possible to produce a reasonable estimate using this approach, few candidates were able to apply it successfully. In both the 2004 and 2005 accident years, some claims occur from policies written under the new conditions and some from policies under the old conditions. Candidates who attempted to adjust only the 2003 and prior years generally did not identify these features of the 2004 and 2005 accident year claims. (v) Business may not be written evenly in the year as more homes are bought and sold during the period April September, so policy cover is more likely to start in this period. It will be important to analyse historical patterns of business written to determine a reasonable assumption. This area of uncertainty will be particularly relevant in light of the timing of the hot dry periods and the timing of the change in cover as this is likely to impact the various proportions of policies on risk affected. Mix of business may have changed. A more granular split of data could be used, for example, separating subsidence claims. The level of exposure accepted may have changed over time. Example of investigation into level of exposure. Assumptions regarding the impact of the hot dry summers will be critical to the estimates, but are likely to contain significant elements of uncertainty in particular, the effect of the 2006 summer, for which little data will exist. It will be important to analyse the pattern of weather / subsidence related claims before and after the dry summers to ensure estimates are as reliable as possible, and discuss any technical engineering issues with relevant experts. Page 5

75 Subject SA3 (General Insurance Specialist Applications) April 2007 Examiners Report Your estimates of the impact of the cover changes may contain significant degrees of uncertainty. Any case estimates may be a particular source of additional uncertainty. Your assumption regarding the underlying increase in incurred claims is likely to contain significant uncertainty. However, it should be possible to assess a range of reasonable estimates and assess the impact of difference assumptions on your reserve estimates. Your predecessor s estimates of the impact of the changes in cover are likely to contain a degree of uncertainty. However, good quality data should be available to assess the two subsidence related items as claim amount and age of home should be available for all homes. May reduce uncertainty by reviewing your predecessor s analyses of these changes. Obtaining second opinions from a peer reviewing actuary should help to improve reliability and the level of confidence in any estimates, thereby reducing some of the uncertainty. Estimates can be compared to benchmarks, industry sources, etc. Comments on question 1(v): Again generally poorly answered with many candidates answers largely limited to repeating the assumptions listed in part (iv) and noting that each may not be valid in practice. Some candidates produced lists of "typical" areas of uncertainty, for example, noting that it was possible that reinsurance arrangements or taxation may have changed. Such answers typically did not sufficiently consider the extent to which assumptions might not be valid, areas of uncertainty and possible ways to improve the reliability of estimates, as requested in the question. Stronger candidates generated a wide range of points. 2 (i) Define Lloyd s A society that provides a market place and regulatory framework within which individual and corporate members may participate in the underwriting of insurance risks on their own account. Define London Market That part of the insurance market in which insurance and reinsurance business is carried out on a face-to-face basis in the City of London. Comments on question 2(i): Bookwork mostly answered well. Page 6

76 Subject SA3 (General Insurance Specialist Applications) April 2007 Examiners Report (ii) Describe the main features of Lloyds Lloyd s does not act as an insurer in its own right and, therefore, carries no insurance risk. The Council of Lloyd s is responsible for management and supervision of the market. The Council delegates day-to-day running to the Committee of Lloyd s, who are responsible for administrative matters. There is statutory actuarial involvement, and a Lloyd s actuary The FSA regulates Lloyd s, (as well as Lloyd s managing agents, members agents and Lloyd s brokers). Members are grouped into syndicates. Members are known as names. Names can be individual or corporate. Corporate names have limited liability. Most individual names have limited liability and there can be no new unlimited liability names. Names are represented by members agents. Each syndicate is run by a managing agent. a company appointed to manage the affairs of the syndicate, appoint the underwriter, and provide technical and administrative services. Some managing agents are quoted companies listed on the stock exchange, others are private companies. In some instances, managing agents act as capital providers to the syndicates they manage so have a dual role as corporate members of the market and managing agents. Business is written through the slip system. Most policy and claims administration is performed by LPSO/Xchanging The members of a syndicate share the risks written by the syndicate s underwriters. However, if a member defaults on their liabilities, the other members of the syndicate are not responsible for them there is no joint and several liability. Because of this, each member is required to provide capital ( Funds at Lloyds ) as security to support their total Lloyd s underwriting business. These funds can be drawn on in the event that the member defaults. The level of funds required depends on the perceived level of risk in the business which they underwrite, and the amount of business written. The Central Fund is available at the discretion of the Council of Lloyd s to meet any valid claim that cannot be met by the resources of any member. Compensation may now also be available from the FSCS. Each syndicate year of account is allowed to remain open, usually for a period of three years, before a profit or loss can be determined for that year. Page 7

77 Subject SA3 (General Insurance Specialist Applications) April 2007 Examiners Report During that time, premiums received on business written in the year are accumulated in a fund, out of which claims and expenses are paid. At the end of the three year period, the fund would usually be closed by estimating the value of the outstanding liabilities and reinsuring them into the subsequent open year of the syndicate. The reinsurance premium for this is known as reinsurance to close (or RITC). Once this transaction has occurred, the final result of the closing year can be determined, as can the profit or loss attributable to each member. If liabilities are particularly uncertain, the year of account may be left open longer than 3 years. (Almost all) business is written through brokers. Lloyd s writes all classes of business, in particular special and unusual risks and some business in most countries of the world. Comments on question 2(ii): This was a straightforward bookwork questions. Full marks were available for candidates who wrote brief notes covering most of the main features. The candidates who failed to achieve a good mark typically wrote answers that contained inaccuracies, or focussed on a small number of features of Lloyd's (iii) Ease of entering market Megasure Group could participate in an existing Lloyd s syndicate by just providing capital. Establishing a wholly owned subsidiary would be more complicated. would need to set-up admin processes / do admin may not have necessary expertise in house/need to hire staff and so this may take more time. This may also lead to a difference in start-up costs of entering market (that is, start-up costs likely to be lower for Lloyd s). Risk of entering a new market likely to be greater if start-up costs are greater. Barriers to Entry It may not be possible for Megasure Group to join the syndicates it wishes to (they may have enough capital already). There may not be syndicates that Megasure Group would like to participate in. As a major international insurance group, there should not be significant problems in obtaining permission to establish a subsidiary. Should also consider ease of leaving market may be easier at Lloyd s. Control Lloyd s syndicates are run by managing agents, who make key decisions such as appointing underwriters. Page 8

78 Subject SA3 (General Insurance Specialist Applications) April 2007 Examiners Report The ability of individual names to control the syndicate may be limited (although Megasure Group s influence will be greater if it provides a significant amount of the syndicate s capital). Megasure could control every aspect of a wholly owned subsidiary, subject only to regulatory constraints. Megasure may have confidential information that a subsidiary could exploit. If Megasure participated as a name on a syndicate, it may be reluctant to share this with the managing agent. Access to preferred risks Underwriters on a syndicate may already be writing the type of business Megasure wishes to write. There may be advantages to writing renewal business on a syndicate than considering risks for the first time at a new subsidiary. The Lloyd s credit rating may assist Megasure in accessing business. Lloyd s may give the start-up more credibility than would be attached to a small start-up (value of Lloyd s brand). Ability to benefit from Lloyd s licences. Existing Lloyd s syndicates would have links to brokers to access risks, and underwriters may have special relationships. Diversification Megasure Group may be able to participate in a number of syndicates, obtaining diversification. Future strategy Consider the long term strategy for the European operations. For example, if more lines of business are planned in the future, may prefer to operate a subsidiary. Regulation There may be differences in the regulatory requirements that make one option preferable. There may be differences in capital requirements. There may be differences in the permitted assets. Tax There may be differences in the tax that make one option preferable. Example of differences. Expected profitability There may be differences in the expected profitability that make one option preferable. Page 9

79 Subject SA3 (General Insurance Specialist Applications) April 2007 Examiners Report Comments on question 2(iii): This question required candidates to apply their knowledge of Lloyd's and the London market set out in parts (i) and (ii) to advise Megasure. Candidates with a good knowledge of the main feature of these markets were able to identify the key differences that would likely be of most interest to Megasure and so scored well. A surprising number of candidates indicated that Megasure could only invest with limited liability through becoming a Lloyd's name. Others suggested that a London market company would not be able to write risks through a slip system. Candidates who did not understand the markets therefore achieved lower scores. (iv) Definitions of RMM/MCR, ECR, ICA RMM Required minimum margin. MCR Minimum capital requirement. RMM and MCR are different abbreviations for the capital requirement. RMM/MCR is the greater of the GICR (general insurance capital requirement)/rms (required margin of solvency) and the minimum guarantee fund (MGF) set by the EU. ECR Enhanced capital requirement. A more risk sensitive measure than the current EU directive minimum. ICA Individual capital assessment. This is a type of capital assessment introduced by the FSA. Insurers are required to carry out regular assessments of the amount and quality of capital that is adequate for the size and nature of their business. Comments on question 2(iv): Bookwork, however many candidates did not know that RMM is the same as MCR. Most candidates were able to define ICA, and many mentioned that this was a type of capital assessment that firms made by considering the risks faced by their business. (v) Initial capitalisation of MICE The MCR/RMM has the force of EU directives, that is, it has the force of law. This represents the minimum level of capital that must be held. The ECR is currently only a private reporting requirement rather than a hard test. However, this is under review / may change in the future. In any case, the ECR will be used as a basis of discussions between firms and the FSA. The ICA represents a firm s own assessment of its capital requirements, so it is unlikely it would want to hold less than this. In practice, it is highly unlikely that the FSA would permit MICE to only hold the MCR/RMM. The ICA is the largest of the three estimates for MICE, so this is probably the minimum level of capital the FSA would permit. The FSA will review the ICA and issue individual capital guidance. Page 10

80 Subject SA3 (General Insurance Specialist Applications) April 2007 Examiners Report ICG will be expressed by the FSA as a percentage of the ECR. The firm would almost certainly want to hold at least the ICG. We don t know what the ICG will be until the FSA has reviewed the ICA. Therefore it is not possible to know with certainty the capital that MICE will need. We could try to obtain information on ICG from other sources to estimate the capital requirements. We may want the company to hold more capital than it is required to hold by the regulator. Additional capital will provide extra flexibility to management. For example, greater flexibility with investment policy. The ICA is an estimate. The company may wish to hold more for prudence. If the company if very thinly capitalised, it may receive unwanted regulatory attention which could distract management. Consider how much capital the parent (Megesure) has. Consider the cost of capital of Megasure and the return of MICE under various levels of capitalisation. Consider costs of over-capitalisation. Opportunity cost consider any alternative uses of capital that Megasure has, and the returns on those activities. Consider alternatives to parent providing capital. The parent could provide a letter of credit rather than capital. The parent could provide addition reinsurance to MICE to reduce its capital requirements. However, these alternatives may not be acceptable to the FSA. Rating agencies what level of capitalisation does MICE require in order to obtain the desired rating. Do potential policyholders or investors require a particular level of capital / rating in order to place business with the company? Consider the capitalisation/ratings of competitors. Where possible, consider future changes in regulation (for example, Solvency II) The estimated capital requirements are higher in 2010 than in The company should consider whether it needs to fund future capital requirements initially. There may be options that don t require this to be funded initially, for example, through retained profits anticipated in the business plan. Megasure will also wish to finance 2007 start-up costs of MICE. Page 11

81 Subject SA3 (General Insurance Specialist Applications) April 2007 Examiners Report Comments on question 2(v): Poorer candidates lack of knowledge really showed here as they were not able to write very much. Often there was a standard list of things you would consider when deciding how much capital to hold. Better candidates tailored this to the specific situation and demonstrated their understanding of the capital requirements necessary now and in the future. Many candidates stated that firms should consider factors such as the potential for accumulation of risk or large losses. Such factors would have been considered in producing the ICA, and candidates were expected to refer to this in their answers. Candidates who produced standard lists of factors to consider when determining capital requirements needs without acknowledging where these were included in the ICA generally scored poorly. (vi) Should reinsurance be purchased? Purchasing reinsurance with a net cost of 1 million reduces the ICA by 5 million. Many of the matters to be considered in deciding on the reinsurance purchase will have been quantified in the ICA. The company should consider the risk reward trade-off when purchasing reinsurance, that is, the cost of the reinsurance and the benefit to MICE. MICE s expected profitability will be higher if reinsurance is not purchased (reinsurance premium is saved). This reinsurance does not seem to reduce MICE s capital requirement by very much. As a result, MICE may be better off not purchasing this reinsurance. Note that there may be a difference between MICE s capital requirements and the ICA estimates (e.g. ICG). 5 million may not be the figure for Megasure to consider. Consider whether the parent has the extra capital available that would be required if reinsurance is not purchased. and what is the opportunity cost of the extra capital. MICE s profits will be more volatile without reinsurance. Consider whether Megasure (and its shareholders) prepared to accept more volatile profits in return for higher expected profitability. Consider any rules Megasure has regarding the reinsurance purchased by its subsidiaries. Megasure is also a reinsurer, so accepting an internal reinsurance may be consistent with its risk tolerance. The ICA amounts are estimates, and may have underestimated the benefit of the reinsurance. Although the reinsurance may not reduce the ICA by much, there may be other benefits. Example of other benefits: e.g. may not reduce the ICA by much, but may reduce ruin probability significantly. The reinsurance premium estimated in the business plan may be wrong. Page 12

82 Subject SA3 (General Insurance Specialist Applications) April 2007 Examiners Report There may be an alternative reinsurance strategy that would better suit MICE. Example of alternative reinsurance strategy: purchase higher limits, purchase more reinstatements. Another example of alternative reinsurance strategy: purchase reinsurance from counterparties with better credit quality. MICE could consider securitisation/art. Consider the availability of reinsurance. Consider what the regulator might think about MICE not purchasing reinsurance. Consider rating agency views. Consider the views of others, e.g. the underwriter, MICE board. Consider competitors reinsurance strategies. Consider possible tax differences. Comments on question 2(vi): Weaker attempts just gave standard lists, hence missing the specifics that applied in the situation, and scored poorly. Again candidates who produced standard lists of factors to consider when determining reinsurance needs without acknowledging where these were included in the ICA generally scored poorly. Some marks were available for comment on the ICA calculations, e.g. consideration of capital requirements if alternative reinsurance was purchased. (vii) Ways to ensure premium adequacy. Detailed repricing of each individual risk offered to MICE. May be too time consuming and expensive to do this for every risk. MICE may not have sufficient internal expertise, especially initially. Data for individual repricing may not be available. May not be possible if need to respond to brokers quickly. Only write in follow market with trusted lead underwriters. Availability market may be limited. Buy or build pricing software. Consider the output from catastrophe models and location models, for example, RMS. Build in set underwriting protocols/guidelines and rating factors. Agree policy wording protocols and exclusions. Software may not work as intended. Cost of buying/building software may be prohibitive. Build tool to monitor the profitability of business being written. Own data will be limited initially. Some third party data will be available. As business is short-tail, own data can be gathered relatively quickly. Hire experienced staff (underwriters, pricing actuaries etc.) with detailed market knowledge. Or engage external consultancy to review processes, controls and outputs. Page 13

83 Subject SA3 (General Insurance Specialist Applications) April 2007 Examiners Report Need to find a way to assess experience. Experienced staff will be expensive. Have internal peer review process. Should focus most attention on largest risks. May not be possible if need to respond to brokers quickly, but can apply results of peer review to future underwriting decisions. Add margins to rates to reduce possibility of rate inadequacy. Rates may become uncompetitive. Ensure adequate premium loadings (commissions, expenses, reinsurance etc.) Comment on practicality of monitoring loadings. Monitor changes in volumes and other movements. May be difficult to identify reasons for any changes. Monitor insurance cycle. May be difficult to accurately determine the position of the market in the cycle. Monitor prices charges by competitors as a check on your own model. It may not be possible to access this information. Competitors may be charging the wrong rates. Comments on question 2(vii): The key features of MICE are that it is a new company, and it is writing London market property business. Candidates were expected to identify methods of monitoring pricing that are appropriate to such a company, and comment on the practicality. Ensuring the reasonableness of the loadings for investment income and fixed expenses would tend to be less important for MICE than some of the other factors identified in the solution. Some candidates devoted most of their answers to expenses and investment income and so omitted to mention other important considerations. Weaker candidates produced answers that didn't reflect the nature of commercial property insurance or were a standard how to price a product answer. (viii) Extra line of business Regulatory considerations. FSA would have to reconsider the authorisation (unless it was already authorised for the new line as part of the original process). A sudden change in the business plan may create a bad impression with regulator. Characteristics of new market For example, size, growth, ease of entry, relationships. Capital requirements of new line of business. Is this capital available? Opportunity cost of capital. Page 14

84 Subject SA3 (General Insurance Specialist Applications) April 2007 Examiners Report Expected profitability/return on capital of new line of business. Consider whether new line is consistent with MICE s risk appetite. There may be a diversification benefit of writing lines of business with low correlations. Synergies with existing book. Does company have sufficient expertise to write this line of business? Would writing a new line of business distract the company from its commercial property targets? It might be better to defer introducing a new line until the company has been established for a couple of years. Consider views of parent. For example, in raising the profile of the new business. Consider views of rating agency. Reinsurance requirements of new line of business. Consider potential for cross-selling. Consider whether system changes would be required. Consider any tax issues. Comments on question 2(viii): This question was generally well answered. END OF EXAMINERS REPORT Page 15

85 Faculty of Actuaries Institute of Actuaries EXAMINATION 1 October 2007 (am) Subject SA3 General Insurance Specialist Applications 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 3 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. SA3 S2007 Faculty of Actuaries Institute of Actuaries

86 1 A student has produced the following tax calculation for a UK resident proprietary general insurance company. The company writes only UK business. Accounting Student's Investment Returns Data Calculation Purchase price of fixed interest securities Market value of fixed interest securities as at 1/1/ Market value of fixed interest securities as at 31/12/ Accrued investment income during Return on fixed interest assets Purchase price of UK equities 30.0 Market value of equities as at 1/1/ Market value of equities as at 31/12/ Net dividend income during Return on UK equities 32.0 Underwriting Result Unearned premiums b/fwd 45.0 Written premiums Unearned premiums c/fwd 50.0 DAC b/fwd 9.0 Acquisition costs paid 18.0 DAC c/fwd 10.0 Reinsurance purchased on 1 January for Earned Premiums net of DAC and Reinsurance 56.0 Outstanding and IBNR claims b/fwd Net Claims paid in Outstanding and IBNR claims c/fwd Allowable Equalisation reserve transfer 10.0 Additional provision for future catastrophes 4.0 Claim handling expenses incurred in Provision for future claim handling expenses for claims incurred in Increase in claims and claims provisions 72.0 Staff and buildings costs 10.0 Underwriting Result % 45.3 Underwriting result after tax Correct the student s tax calculation and state the underlying principles that explain how each accounting item should be treated. You may ignore any interim arrangements and can assume that the accounting items given are correct. [11] SA3 S2007 2

87 2 Company A is a large insurance group with worldwide operations. One of its small subsidiary companies, Company B, is a UK company that started writing international property and liability reinsurance business in Company B took the decision to pull out of the US reinsurance market in 1980 and since then has focused on writing a small and very profitable European property reinsurance book. Company B s discontinued portfolio currently consists largely of US Asbestos, Pollution and Health Hazard ( APH ) liabilities. In recent years, Company A has needed to inject more capital into Company B following reserve deteriorations on the US APH liabilities. The technical reserves for Company B are established on a discounted basis. The Board of Company A is currently considering selling Company B in view of Company A s worldwide strategy to focus on writing direct business. (i) Describe the major areas of risk facing Company A in respect of the APH claims liabilities of Company B. [7] (ii) Suggest the benefits to Company A of selling Company B. [5] (iii) Discuss alternative options open to Company A to remove the risks of the APH liabilities within Company B, explaining their advantages and disadvantages. Company A has already dismissed the use of an adverse development cover. [10] Company C has shown an interest in acquiring Company B s APH liabilities from Company A. Company C has proposed that it acquires the APH liabilities in return for the transfer of assets equivalent to the discounted claims reserves (including claims handling expenses) on a High estimate basis, where High estimates are deemed adequate in 90% of future possible outcomes. The company actuary for Company B has provided the following estimates in respect of the APH liabilities as at 31 December Figures in US$m Case reserves Annual Average Paid (last 3 years) Best estimate reserves Undiscounted Discounted 4% High estimate reserves Undiscounted Discounted 4% Asbestos Pollution Health Hazards Subtotal Claims handling expenses Total Company B s assets have produced investment return averaging 4.2% per annum over the last 3 years. (iv) Suggest the benefits to Company C of acquiring the APH liabilities. [5] (v) (a) Estimate the discounted mean terms of each claim type on each of the Best estimate and High estimate bases. (vi) (b) Comment on the reasonableness of the relative length of these discounted mean terms. [9] Set out the challenges that you would make in regard to the numbers in the table above when assisting Company C in its initial price negotiations for this portfolio. [9] [Total 45] SA3 S PLEASE TURN OVER

88 3 You have recently joined a large general insurance company and you are determining the reserves for a portfolio of business in the first quarter of 2007, using annual data as at 31 December The company business plan for the 2004 year shows a planned ultimate loss ratio of 85%. The company stopped writing this portfolio at the end of You have the following summary information readily available: Underwriting Years Premiums million Reported loss ratio Basic chain ladder ultimate loss ratio % Booked ultimate loss ratio % A priori * loss ratio % Mean term of paid claims In years 4.0 Development year Age to age factors n to n + 1(reported claims) * a priori in this context refers to the initial estimate ultimate loss ratio used in the Bornhuetter-Ferguson calculation As part of your review you investigate other sources of information. You discover that: The 2003 and prior years are running off as planned. A company pricing database shows that the average rate change across policies in 2004 is minus 10%. The ex-underwriter of the account tells you that he feels that rates were showing a ten to fifteen percent reduction and that some policies had wordings which gave wider coverage than in previous years. (i) (a) Calculate the Bornhuetter-Ferguson and chain ladder estimated ultimate loss ratios for the 2003 and 2004 years. (b) Comment on the difference between the Bornhuetter-Ferguson and chain ladder expected ultimate claims. [6] (ii) (a) Derive three alternative a priori loss ratios for use in the Bornhuetter- Ferguson method for the 2004 year. (b) Calculate three alternative Bornhuetter-Ferguson ultimate loss ratios using your estimates from part (a) and tabulate your results. [5] SA3 S2007 4

89 (iii) (a) State the concerns that you would have with the 2004 initial a priori loss ratio and the new a priori loss ratios you have derived in part (ii). (b) Comment on the calculated ultimate loss ratios. [9] The company finance director tells you that it has always been company practice to use the budgeted loss ratios in the Bornhuetter-Ferguson calculations. He has seen your table of results and states that the Bornhuetter- Ferguson method is not credible as it can give any result that you may want. He tells you that he intends to use the ultimate claims using the budgeted loss ratio in the Bornhuetter-Ferguson calculation. (iv) Discuss the finance director s comment on the credibility of the Bornhuetter-Ferguson method. [5] (v) (a) Select one a priori ultimate loss ratio for the 2004 year and calculate the increase in reserves needed if the company changes its a priori loss ratio to your figure and (b) Comment on the materiality of this difference if the company follows its usual practice. [5] A broker has approached the company offering to arrange an adverse development cover to reinsure this portfolio at a price that you estimate to be best estimate loss cost plus 30% load plus brokerage. (vi) Explain the term adverse development cover. [2] (vii) Explain the risks to the ceding company of reinsuring this portfolio and the risks to the reinsurance company of writing this portfolio and explain what each company can do to mitigate its risks. [9] (viii) State with reasons whether you think that such a policy would be appropriate in this situation. [3] [Total 44] END OF PAPER SA3 S2007 5

90 Faculty of Actuaries Institute of Actuaries EXAMINATION September 2007 Subject SA3 General Insurance Specialist Applications EXAMINERS REPORT Introduction The attached subject report has been written by the Principal Examiner with the aim of helping candidates. The questions and comments are based around Core Reading as the interpretation of the syllabus to which the examiners are working. They have however given credit for any alternative approach or interpretation which they consider to be reasonable. M Stocker Chairman of the Board of Examiners December 2007 Comments Individual comments are shown after each part-question Faculty of Actuaries Institute of Actuaries

91 Subject SA3 (General Insurance Specialist Applications) September 2007 Examiners Report 1 Investment Returns Corrected Calculation Purchase price of fixed interest securities Market value of fixed interest securities as at 1/1/ Market value of fixed interest securities as at 31/12/ Accrued investment income during Return on fixed interest assets = {Accrued investment income} + 31/12/2006} - 1/1/2006} = 25 + ( ) = Purchase price of UK equities 30.0 Market value UK equities as at 1/1/ Market value of UK equities as at 31/12/ Net Dividend income during Return on UK equities = {Net dividend income} + 31/12/2006} - 1/1/2006} = 2 + (60-55) = Underwriting Result Unearned premiums b/fwd 45.0 Written premiums Unearned premiums c/fwd (50.0) DAC b/fwd (9.0) Acquisition costs paid (18.0) DAC c/fwd 10.0 Reinsurance purchased on 1.1 for 2006 (20.0) Earned Premiums net of DAC and Reinsurance = {Unearned Premiums b/f} + {Written Premiums} - {Unearned Premiums b/f} - {DAC b/f} - {Acquisition costs paid} + {DAC c/f} - {Net Cost of Reinsurance} = = Outstanding and IBNR claims b/fwd Net Claims paid in 2006 (60.0) Outstanding and IBNR claims c/fwd (475.0) Allowable equalisation reserve transfer (10.0) Additional provision for future catastrophes 0.0 Claim handling expenses paid in 2006 (3.0) Provision for future claim handling expenses for claims incurred in Increase in Claims and claims provisions = {OS & IBNR b/f} - {Net claims paid} - {OS & IBNR c/f} - {Allowable equalisation reserve transfer} - {CHE} = = -63 (63.0) Staff and buildings costs (10.0) Page 2

92 Subject SA3 (General Insurance Specialist Applications) September 2007 Examiners Report Technical Result = {Fixed interest return} + {Equity Return} + {Net Earned Premiums} {Increase in paid claims and claims provisions paid} = = of which no further tax due on dividend income 2.0 Taxable result = 12 2 = % = = 3.0 (3.0) Underwriting result after tax = 12 3 = Alternative solution: Gross Earned Premium 100-(50-45) = 95 Less Earned RI (20) Net Earned Premium = 75 Incurred Claims = (50) Allowable Expenses 31 Increase in DAC 1 Underwriting result = (5) Taxable fixed interest return 20 Taxable return on equities 5 Equalisation reserve provision (10) Taxable result = 10 30% (3) Franked income from equities 2 Technical result after tax = 9 Investment Return From Bonds or Loan relationships is taxed on the total returns whether realised or unrealised. The bonds are valued on a mark to market basis. Dividends from UK equities are not taxed further. Gains are taxed on a mark to market basis. Underwriting result taxable as follows: Earned Premiums (net of RI), so unearned premiums net of DAC tax deductible Expenses are tax deductible (acquisition costs, running costs of the business, ) Less claims handling expense provision is allowable to the extent that the expenses relate directly to claims for which claims provisions have been accepted by HMRC. Less paid claims Less change in o/s claims carried forward supported by case estimates or statistical projections Change in IBNR subject to justification Sensible mention of discounting. The insurance technical provisions claimed for tax purposes are net of amounts recoverable from reinsurers. For tax purposes it is necessary to assume that all amounts due will be recovered. A deduction is allowed for specific provisions for amounts estimated to be irrecoverable from reinsurers but a general provision is not allowed. In the UK, insurers are required to establish an Equalisation Reserve/provision over and above their claims provisions in respect of certain classes of business (regarded as Page 3

93 Subject SA3 (General Insurance Specialist Applications) September 2007 Examiners Report being potentially volatile). Statutory rules govern the calculation of transfers to the Reserve (which are tax deductible) and transfers from the Reserve (on which tax is payable). Provisions for future catastrophe losses are not allowable except where required by law Comments on Q1. The template given should have guided the layout of the answer required. A minority of students followed this template and scored well. Those who chose their own format often made mistakes and the answers were harder to follow. Most candidates showed a reasonable grasp of the basics concerning equities and bonds returns and made a decent effort at correcting the calculation. However, very few candidates made many sensible comments on the principles of taxation ( e.g. IBNR is deductible only subject to justification, change in outstanding claims is deductible provided that supported by case estimates or projections) so very few candidates scored highly on this question. 2 (i) APH risks Claims reserves very uncertain because APH liabilities are long tailed due to long latency period (could be inadequate) Liabilities stem from early years when policy records may be incomplete: difficult to assess full extent of exposures Liabilities increase leaving the reserves inadequate due to: (need reason) Risk of legal judgements increasing liabilities Change to regulatory environment Risk of new latent diseases emerging thus increasing liabilities Propensity to claim Claim inflation higher than expected Gearing for RI policies Risk of accumulations Risk around the value of the discount within the discounted reserves: + Timing of claims payments is uncertain can be difficult to assess cashflows + May not achieve return on assets implied by discount rate. Currency risk if liabilities not matched Mismatching of assets and liabilities Risk of disputes and bad debt on outwards reinsurance given the age of the liabilities Claims handing cost could be higher than expected (for various reasons, legal, cost of specialist handlers etc ) Comments on Q2(i). This was answered well by most candidates. (ii) Benefits of sale Removes risk of further reserve deterioration on APH More stability (less volatility) No longer distracts Company A management from ongoing business frees up resources (future strategy) Page 4

94 Subject SA3 (General Insurance Specialist Applications) September 2007 Examiners Report Brokers, potential customers and rating agencies may have undervalued Company A because of APH liabilities of B Sale of B may result in enhanced sale value of A and increase ability to issue debt Administrative savings Extract capital from Company B (less capital needed) May get a good deal Comments on Q2(ii). This was answered reasonably well. (iii) Alternative options Part VII transfer to external company (or, alternatively, for Loss Portfolio Transfer and Novation) + legal liability transferred + so employee and shareholder rights not affected + may improve the sale terms of Company B + can transfer to specialist APH run-off company + don t have to transfer non APH policies need to get regulatory/court approval which can be time consuming possible reputational risk will need to commission an independent expert to opine on policyholder protection this could be expensive Proactive commutation of policies + does not normally require regulatory approval + opportunity to make profits on individual policies can be time consuming and needs senior input will be impractical to commute all the policies and unlikely to be able to remove all exposures this way Scheme of arrangement + Can achieve finality + Do not have to get agreement from every policyholder May be reputational issues for Company A if scheme fails or seen to be unfair Can take some time to set up May not have expertise in house to plan or execute Comments on Q2(iii). This was poorly answered. Many candidates gave answers that either would not remove the liability from the company (e.g. ring fence within company) or were very unlikely to be realistic or practical. Those candidates that did suggest a Part VII transfer or a scheme of arrangement often did not give sufficient further detail. The wording of many candidates answers gave the impression that the portfolio could be sold and all associated capital would be released. If such a transfer were to take place then a premium over the reserves will almost certainly be paid and this could be greater than the capital held. Loss portfolio transfers answer the question correctly only if they transfer legal liability. In the UK this is called a Part VII transfer, other legislation existing in other counties. Page 5

95 Subject SA3 (General Insurance Specialist Applications) September 2007 Examiners Report (iv) Benefits of acquiring Make a profit and/or diversify but VERY unlikely best estimate reserves may be prudent following reserve injections actual investment return is greater than assumed in the value of the discount deal done on high estimate basis, for which reserves are an additional 50% on best estimate Expertise to be able to assess risks and price portfolio May have experience of doing schemes of arrangement May have own APH department so gain from economies of scale May have specialist claims handling and commutations expertise Bargaining power for class actions, set-off rights with brokers and reinsurers Better bargain with claimants if not involved in writing current business Comments on Q2(iv). Most candidates did not give enough weight in their answers to the benefits of scale, expertise and bargaining power of a specialist company taking on this portfolio. (v) (a) Estimate discounted mean term Discounted reserves ~ undiscounted reserves (1 + interest rate) -DMT So DMT can be estimated by ln(undiscounted/discounted)/ln(1 + discount rate) Liability Type Best DMT High DMT Asbestos Pollution Health Hazard Claim Handling Expenses (b) Reasonableness: Asbestos DMT higher than others reflecting longer latency period of asbestos Some of pollution liabilities relate to clean up costs, which are not bodily injury claims so slightly shorter than asbestos Pollution mean term could be a bit short Pollution best = high could be an error (or other sensible comment) Health hazards DMT would depend on claim type but expected to be shorter tail than asbestos Health Hazard estimated DMT seems too low: may be error Health Hazard is more dependent on latent claims (IBNR) as low ratio of paid claims to case reserves therefore expect a bigger difference between best DMT and high DMT Asbestos High DMT > Best DMT Page 6

96 Subject SA3 (General Insurance Specialist Applications) September 2007 Examiners Report May be reasonable if assume longer payment pattern accompanies deteriorating experience Because it would take time to deteriorate Reasons for deterioration: more new claims reported than expected inflation of average claims costs higher than expected more mesothelioma claims (longer latency period and higher average cost) Comments on Q2(v). A surprising number of candidates were unable to calculate the DMT s and those that were able to do the calculation typically made only brief comments. (vi) Challenges Company C wants the amount of assets transferred to be as high as possible therefore challenges should focus on increasing discounted High estimates Discount rate may be too high and therefore discounted High reserves too low need to allow for risk of past returns not being achieved in future especially as need to consider long future payment patterns Nature of liabilities => outcome is very uncertain Calculation of IBNR to OS ratios Calculation of survival ratios Ratio between High and Best reserves is the same at 1.5 for all claim types How likely is it that the High estimates represent the 90th percentile? Data provided are inadequate would want to see lots more (need valid example of extra data) Asbestos probably more uncertain than pollution due to longer latency and mean term to settlement => may need to increase High estimate for asbestos Based on average claims payments, Health Hazards reserve could be exhausted in 2.5 years. How to allow for possibility of later emergence of claims e.g. lead paint, new claim types? Survival ratio for Claims handling expenses is just over three years, far less than the DMT s would suggest. Claims handling expense reserve appears to be understated. The ratio of High to Best undiscounted reserves is the same for claims handling expenses as for claims reserves. You might expect claims handling expenses to be proportionately higher than this in view of reducing economies of scale as time goes on What downside scenarios have been considered in assessing the range? E.g. US legal developments Rapid increase in claims inflation Comments on Q2(vi). Candidates missed many obvious challenges in this question and most did not consider calculating survival or IBNR to outstanding ratios Page 7

97 Subject SA3 (General Insurance Specialist Applications) September 2007 Examiners Report 3 (i) development year Age to age factors n to n+1(reported claims) Age to ult factor /cumf /cumf BCL for 2003 = = 91.3 BF for 2003 = = 91.6 BCL for 2004 = = BF for 2004 = = 93.7 Chain ladder does not take account of prior expectations and therefore projects the ultimate without adjustment because a priori loss ratio in line with experience because a priori not in line with experience It is the same as using the bf method with an a priori ultimate of 113.7% The BF method is credibility weighted to take account of prior knowledge. BCL could be distorted by one or two large claims hence big difference If the a priori estimate is closer to the real ultimate then thebf method will give a more accurate result and vice versa Which means that great care needs to be taken in selecting the a priori estimate. Comments on Q3(i). All candidates should have scored full marks for the technical part of the reserving calculations. However, some candidates did not appear to know how to perform a BF calculation and others calculated it in a very inefficient way thus wasting valuable time. Also basic errors were made by some candidates. (ii) (2003 and 2004 booked starting points given in the table below is a better starting point given the implausible 2004 number. There are other valid starting points including prior year basic chain ladder estimated ultimate loss ratios.) (Increase in reserves shown here for part v calc) There are alternative starting points e.g. 2003, BCL. Correct application of rate reductions: Calculation of ultimates: Clear tabulation of results Page 8

98 Subject SA3 (General Insurance Specialist Applications) September 2007 Examiners Report increase in reserves from bf ult of 93.7 (using an 85 a priori LR) increase in reserves from 85% booked loss ratio a priori LR bf ult using 2003 as a base with 10% rate reduction > with 15% rate reduction > with 20% rate reduction > with 30% rate reduction > using 2004 as a base with 10% rate reduction > with 15% rate reduction > with 20% rate reduction > with 30% rate reduction > Comments on Q3(ii). Almost all candidates were able to select three ratios for use in the BF. Some candidates were happy to select unhelpful a prioris (ignoring information given) or made selections which were near-identical (e.g. comparing a volume weighted average with a simple average) missing the much greater uncertainty in other assumptions. The better candidates recognised that the key issue is one of uncertainty and calculated a range of a priori estimates accordingly. Mistakes were often made in the calculation of rate change impact. The better candidates recognised that there may well be claims trend in addition to the rate weakening. Many candidates dropped easy marks for not tabulating the results as instructed. (iii) Original loss ratio Original (budgeted) a priori loss ratio is now over three years old. And we have newer information which suggests that this estimate is optimistic. And could easily be 30 points out, significantly distorting the ultimate Need to ask questions about currency of claims as could cause distortions New estimate a priori loss ratios The pricing database is an unknown to us and we do not know how the figures are calculated. Example required of why this may be a problem, e.g. granularity. Assuming the calculations are correct then this estimate is very different to that assumed in the budget Budget assumes approximately 8% rate increase compared to 10 point decrease, an 18 point gap. It is unlikely that the rate changes due to wording changes will be accurately recorded, if at all. The rate reduction may well be calculated as a change in premium per unit of exposure which will not take into account inflation of loss cost over the year, in which case the rate change will be worse by the amount of loss inflation (e.g. 4%) Page 9

99 Subject SA3 (General Insurance Specialist Applications) September 2007 Examiners Report The underwriter s estimate will probably be influenced (biased) by the calculated rate change and the poor experience of the portfolio to date, and it is likely that his figure is based on some of the larger and more memorable policies in the portfolio. However, his judgement seems to be credible. The difficulty is in knowing how much to add for the widening of policy coverages but bearing in mind that rate reductions are normally underestimated in a softening market The true rate softening could easily be double the estimated 10%. This is more worrying given the sudden increase in the portfolio premiums from an otherwise stable position. Ultimate loss ratio The reported to date loss ratio for 2004 would suggest an ultimate loss ratio significantly higher than 85% using BCL Using the 10% reduction gives a loss ratio 15 points higher (or alternative suggestion) With different plausible assumptions there is a large range in the calculated answers BCL could be distorted by one or two large claims hence making a big difference so it could be difficult to settle on one estimate The range gives us significant concern over the budgeted ultimate.as 85% is below the bottom of our range. Comments on Q3(iii). Very few candidates raised questions on the pricing database and the way it calculates a rate change. Also many candidates did not discuss the difficulty of taking account of the underwriter s comments appropriately. Several candidates chose to dismiss the underwriter s views entirely and thus discarded a valuable source of information. Most candidates got very low marks on this part. (iv) It is true that the BF method relies heavily, even critically, on the a priori estimate which is a strength if the a priori is chosen well and a weakness if chosen badly. Indications are that the selected a priori estimate needs revision as evidenced by the high reported loss ratio for a year at the end of 36 months the rate reduction estimates in the database and from the underwriter The company should be trying to book best estimate results which means using the best information available and should take precedence over an established practice which in this instance looks like it is not giving a good solution. Comments on Q3(iv. Most candidates made some reasonable points in discussing the BF reliance on its a priori. However, few candidates stated clearly that reserves should be calculated as best estimates using the most up to date information. Most candidates gave a general description of the BF method and failed to tailor their answer to the specific circumstances given in the question and thus missed many easy marks. There was significant misunderstanding of what independent means in relation to the BF method. Page 10

100 Subject SA3 (General Insurance Specialist Applications) September 2007 Examiners Report A commonly held incorrect view was that no information derived from the year in question could be used. Rate changes, claims inflation, wider wordings and increasing premium volume are all independent and should be used in determining a best estimate a priori. (v) For calculation of reserve deterioration see above tabulation Selecting one number: e.g. 20% rate reduction on 2003 gives a priori loss ratio of 115%. This gives an ultimate loss ratio of 114.6% The increase in reserves is the change in IBNR So the reserve deterioration is the premium multiplied by the change in ULR = 20.1 x (114.6% -85%) = 5.95m Calculating reserve deterioration: Ultimate claims are approximately 90m 92% = 83m for the portfolio Assume paid claims are at 25% which means reserves are about 62m Then the increase in reserves will be about 5.95/62 = 9.6% This has borderline materiality for this portfolio but will be immaterial for the whole company. One should check that this is an isolated instance and not systematic, in which case the overall impact may well be material. Comments on Q3(v). Most candidates were able to calculate the reserve deterioration but very few considered paid claims and therefore the likely impact on unpaid claims. Further a surprising number of candidates did not pick up that for a large company this deterioration in itself is unlikely to be significant. (vi) Adverse development cover pays for the deterioration in claims over a specified period in excess of a pre-agreed amount. The deterioration can be measured using paid claims or reported claims The specified period would normally be more than one year. It is usual for the ceding company to retain a share of the claims i.e. less than 100% is ceded. Comments on Q3(vi). Most candidates appeared to know broadly what an adverse development cover was, but missed the detail. (vii) Risks to ceding company: Claims experience is better than expected and the company pays the claims and the reinsurance premium Claims could deteriorate outside of the period of cover and therefore not be reinsured. Claims could deteriorate badly and the company s retained share could still be significant. The reinsurer could fail Page 11

101 Subject SA3 (General Insurance Specialist Applications) September 2007 Examiners Report Mitigated by: Negotiating the lowest premium possible Retaining the minimum possible share Spreading the ceded risk amongst several reinsurers Using only top credit rated reinsurers Risks to the reinsurer Underwriting risk takes on a risk which is worse than anticipated at too low a premium Timing of claims happens inside the covered period Legislation/judicial decisions/interpretation mean that the original policies have wider coverage than expected, and hence claims more than expected. which may accumulate with other risks that it has. There may be significant latent claims in the portfolio. Currency fluctuations could make the claims larger than expected Invested assets may perform worse than assumed in any calculation of premiums. Moral hazard from the cedant, manipulating claims payment/reporting to fall within the policy period. Mitigated by: Thorough analysis and investigation of the policy and claims files Purchasing reinsurance Careful monitoring and limiting of aggregates Hedging of currency Diversification of assets Participation clause Increase profit margin Claims audits to verify no changes in claims procedures. Comments on Q3(vii). Most candidates gave reasonable answers, but only identified a few of the risks to the reinsurer. (viii) I would not think that buying this policy would be appropriate in this instance. (or clear statement of opposite opinion) All years except for 2004 seem to be running off to the recognised pattern With the exception of 2004.which will attract more scrutiny and a higher premium anyway. The total reserve size is small and any adverse development is likely to be much smaller Page 12

102 Subject SA3 (General Insurance Specialist Applications) September 2007 Examiners Report So unless the company s solvency is very tight this does not look like a good option as the company will be ceding profit and paying brokerage when the company should be well able to pay the claims without reinsurance. Comments on Q3(viii). Many candidates answered this well. However some lost marks by not stating a clear preference on whether the cover is appropriate in this case. END OF EXAMINERS REPORT Page 13

103 Faculty of Actuaries Institute of Actuaries EXAMINATION 14 April 2008 (pm) Subject SA3 General Insurance Specialist Applications 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 both 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. SA3 A2008 Faculty of Actuaries Institute of Actuaries

104 1 You are the actuary responsible for estimating the reserves for a large UK general insurance company with several lines of business. Below is the gross claims development for the public liability class of business and your estimates of the gross ultimate claims at year end Figures in 000s Notified Claims Policy Development Quarter Year ,691 10,256 11,956 11,421 11, ,649 3,146 3,265 3, ,652 11,423 10, ,428 23, ,513 Figures in 000s Year End Year End Estimated Policy Notified Paid Ultimate Year Claims Claims Claims ,565 7,716 12, ,684 2,431 4, ,875 3,898 13, ,453 3,596 38, ,513 1,006 35,125 Total 61,089 18, ,286 At year end 2006 you estimated the following range of gross ultimate claims for this class of business: Range of estimated ultimates ( 000s) - Percentiles 65% 70% 75% 80% 85% 90% 95% 105, , , , , , ,666 The underwriter for this line of business calls you to explain that policies are written on a claims made basis and have been since He is worried that you are not taking account of this in your projections as you seem to have significant IBNR in prior years. (i) Define the term claims made policy. [1] (ii) List the advantages and disadvantages to an insurer of this type of wording. [3] (iii) (iv) Outline the points that you would make to the underwriter in explaining your estimate of ultimate claims in prior years. [4] Explain whether the actuary responsible for reserves should provide a range of estimates in a reserve report. [5] You estimated the range at year end 2006 using scenario testing and your judgement. (v) Explain the advantages and disadvantages of this approach in calculating a range. [4] SA3 A2008 2

105 You have been asked to consider two further ways of deriving a range: Bootstrapping and Mack s method. (vi) Describe each of these methods, giving its advantages and disadvantages. [14] You now have six additional months of data. The latest notified claims and your new estimated ultimate claims as at 30 June 2007 are as follows: Figures in 000s Policy Notified Estimated Year Claims Ultimate ,565 12, ,774 4, ,848 13, ,910 65, ,542 41,256 Total 91, ,732 You mention this to a colleague who comments that: the ultimate level is inconsistent with the range that you provided at year end this might have a significant impact on the company s ICA. (vii) State with reasons whether you agree with these comments. [10] The premium for each of the years is shown below: Figures in 000s Gross Policy Written Year Premium , , , , ,684 Total 110,389 You have been asked by the finance director whether this is a sufficiently profitable line of business following the change to the claims made basis as from (viii) Outline the points that you would make to your finance director and detail any further information that you might require. [18] [Total 59] SA3 A PLEASE TURN OVER

106 2 Rapidco is a large industrial company based in the United Kingdom. The company has seen rapid expansion over the past ten years, doubling its output through automation of key processes while keeping its workforce at similar levels and increasing the number of manufacturing sites it owns by over fifty percent. You are an independent actuary engaged by the company s directors. The directors believe that the company has a very low reported claims record over the past ten years. They believe that the insurance premiums are too high as they are paying their insurers standard book rates with the exception of the fleet portfolio which is experience rated. Its main other insurances are predominantly commercial fire, business interruption, employer s liability, public liability and goods in transit. The company does not buy product liability cover. (i) Discuss the features of past loss experience and exposure that you would need to consider in advising the company s directors on its insurance premium. [18] The company is part of a world-wide manufacturing group with subsidiaries in other countries. The group is considering establishing a captive in one of the non EU countries in which it operates. (ii) Define the term captive. [2] (iii) State the advantages and disadvantages to the group in setting up this captive. [6] You have been asked to advise on: the capital requirements of this general insurance subsidiary. the establishment of its reinsurance programme. (iv) Comment on the factors that you would take into account in formulating your recommendations. [15] [Total 41] END OF PAPER SA3 A2008 4

107 Faculty of Actuaries Institute of Actuaries Subject SA3 General Insurance Specialist Applications EXAMINERS REPORT April 2008 Introduction The attached subject report has been written by the Principal Examiner with the aim of helping candidates. The questions and comments are based around Core Reading as the interpretation of the syllabus to which the examiners are working. They have however given credit for any alternative approach or interpretation which they consider to be reasonable. M A Stocker Chairman of the Board of Examiners June 2008 Comments Individual comments are shown after the solutions to each part question that follows. Faculty of Actuaries Institute of Actuaries

108 Subject SA3 (General Insurance Specialist Applications) April 2008 Examiners Report 1 (i) A claims made policy is one that covers all claims reported to an insurer within the policy period irrespective of when they occurred. Comments on Question 1(i): Bookwork question with most candidates scoring well. (ii) + Limits exposure to latent claims via recent retroactive date + Quicker reporting of claims to ensure that coverage is triggered + Greater clarity on which insurance period is triggered by a claim + Reduced chance of (expensive) legal action between insurers to assess who is on-risk for a claim + Insurer can determine profit/losses more quickly less uncertainty + Potentially easier to reserve - Notification of greater number of claims/circumstances - Risk of moral hazard where an insured takes out a policy being aware that a claim has incurred in order to claim under the claims made policy if the insured has not been on claims made cover before - LOD is the norm so out of line with the competition - claims emerge from different periods of exposure Comments on Question 1(ii): Generally well answered by most candidates. Better candidates recognised that exposure to latent claims could be reduced via a retroactive date. Poorer candidates incorrectly stated that moving from a losses occurring basis to a claims made basis created gaps in cover. (iii) Although all claims have to be reported within the exposure period of the policy, this does not mean that they will be paid within this period so uncertainty remains Most annual policies will still have exposure after end of year There may be policies for longer than one year or binders/lineslips meaning further claims possible after more than one year Claims could re-open May be options for extension of notification period Might expect more notifications to come late in the policy term IT delays may cause further delay There may be little information available on a claim / notification of circumstance when it is first reported, so it may be difficult to set up an appropriate reserve This could be especially true where companies laundry list claims attempting to ensure that all potential incidents which could lead to a claim (however unlikely) are reported to the insurer so that they would be covered under the claims made trigger The claims made trigger has been in place for some years, and there are increases in incurred claims in years 4 and 5 of development Public liability covers damage to 3rd party property and bodily injury claims. The latter can be subject to a high degree of uncertainty and may take a long time to settle Comments on Question 1(iii): Reasonable attempts were made by most candidates on this question. Better answers appreciated the potential for new claims on the most Page 2

109 Subject SA3 (General Insurance Specialist Applications) April 2008 Examiners Report recent year even though the basis is "claims made", and used the data provided to demonstrate the need for IBNER. (iv) Range requirement Reserve report likely to be formal in GN12 terms GN12 states that report should normally indicate the nature, degree and sources of uncertainty surrounding the results and sensitivities to key assumptions Uncertainty should normally be quantified where practicable but otherwise should normally be reported using an appropriate descriptive summary This would suggest that it might be necessary to provide a quantitative range of reserves in order to be compliant with Institute guidance except where impractical when a description might suffice Consider GN50 which states that uncertainty surrounding advice or opinions formed must be considered and communicated appropriately The less likely the audience is to appreciate the importance or extent of uncertainty the greater is the need for this to be communicated In this case the audience may be unlikely to appreciate extent of uncertainty without some quantitative calculation e.g. a range Comments on Question 1(iv): Most candidates mentioned GN12 and some of the advice therein. Few candidates demonstrated full knowledge of the relevant parts of GN12 and GN50. Better candidates identified the need to consider communication in the context of the audience of the report. (v) + No need for any proprietary software or programming skills + Very flexible to different situations + Easy to involve other stakeholders e.g. underwriters + particularly important for this line of business as limited data may be available due to change to claims made in Highly dependent on the experience of the actuary applying the judgement / not objective + This could be an advantage where actuary has appropriate experience/skill + Should be easier to explain to any audience than more technical methods + Potentially allow for model error as well as parameter and process error - Difficult to avoid being anchored to estimates provided in different context - little data on extreme events so difficult to model catastrophes - difficult to model correlations - difficult to check / peer review Comments on Question 1(v): Many candidates scored well here. Better candidates went beyond general comments such as "easy to do" (which is far from clear!) and gave opinions as to which aspects might require specialised judgement and the associated difficulties. Page 3

110 Subject SA3 (General Insurance Specialist Applications) April 2008 Examiners Report (vi) Bootstrapping characteristics: A method of estimating the parameter uncertainty surrounding an estimate of the reserves To estimate process uncertainty need to use in conjunction with e.g. Mack or over-dispersed Poisson model Estimation achieved by repeated re-sampling with replacement from the historic data to produce a large number of alternative pseudo-data sets consistent with the original data. Each of these alternative data sets is projected using the chosen projection method to give an alternative reserve estimate for each re-sampled set of data By repeating this process thousands of times we can generate standard deviations, confidence intervals Can be applied to paid or incurred data, and accident year or underwriting year cohorts Open to manipulation Bootstrapping- pros/cons + Easy to apply for most datasets + customisable - No allowance for tail factor - Basic method very restrictive in terms of how development factors are selected + however method can be applied to subjectively derived development factors Mack s Method characteristics: An analytical method based on the chain ladder for estimating the uncertainty inherent in the reserve estimate for a given accident or underwriting year A standard chain ladder method is applied to the cumulative triangle to determine the incremental development factors. Variability between the actual and expected development at each point in the triangle is calculated. Then the variability across the rows is aggregated to produce a standard error for each accident/ underwriting year Can extend to derive a standard error of the overall reserve estimate However, if percentiles are required, in order to produce a range, a distribution needs to be assumed via a deterministic calculation or bootstrap approach Based on chain ladder so assume underlying chain ladder assumptions appropriate Can be applied to paid or incurred data, and accident year or underwriting year cohorts Mack s method pros/cons + No assumption of prior distribution + A tail factor can be incorporated as a deterministic multiple -Limited judgement possible Both methods pros/cons + Require few assumptions Page 4

111 Subject SA3 (General Insurance Specialist Applications) April 2008 Examiners Report + Easy to use can be run in Excel or proprietary software may contain a version of the method + Increasing usage of methods in insurance industry - Dependent on the quality of data used - Output may reflect variability of data which is a feature of data errors/inconsistency rather than the underlying claim features - Any variability not included in the data will not be reflected in the derived range - This is a particular problem where limited data are available which is likely to be the case for this line of business - Difficult to explain to non-technical audience + Objective + Can audit and peer review Comments on Question 1(vi): Generally poorly answered. Alternative acceptable answers were given equivalent marks for this question, e.g. giving a brief example of bootstrapping in place of an explanation. Many candidates gave a reasonable explanation of bootstrapping; fewer demonstrated knowledge of Mack. Most candidates scored poorly on identifying the advantages and disadvantages of each method. Better candidates identified that Mack s method could be used as part of a bootstrapping exercise. Not many candidates picked up on the marks available for non-technical observations such as the need for sufficient data, failure to reflect variability not in the data etc. (vii) Inconsistent with range Latest ultimate is not inconsistent with range Latest ultimate is greater than 90 th percentile at year end One in ten years, might expect ultimate to be greater than 90 th percentile Ultimate is below 95 th percentile so still within this part of range Change in ultimate largely driven by huge ( 27.5m) increase in incurred claims in 2005 policy year This might be caused by a single unexpected large claim, accumulation of claims, class actions Public liability is always exposed to such claims 2006 policy year has also seen worse than expected development Earlier years have not seen large increases so may not be indication of need for heavier tail factor Impact on ICA Unlikely (in itself) to have significant impact on ICA Only one line out of several other lines may have seen better than expected development ICA calibrated to 1 in 200 year event Increase may not be that significant in comparison to overall reserve size Diversification benefits from multiple lines Need to consider impact of reinsurance In particular if increase caused by single large claim with XOL reinsurance Many other elements than risk of reserve deterioration included in ICA: Operational risk Credit risk Page 5

112 Subject SA3 (General Insurance Specialist Applications) April 2008 Examiners Report Market risk Liquidity risk Group risk Might impact ICA if change not because of volatility but e.g. legal ruling Comments on Question 1(vii): Many candidates failed to answer the question as they did not specify whether they agreed with the comments. Some also did not explain the significance of other influences on the ICA. (viii) Observations Loss ratio is volatile over time Varies from 36% to 260% Loss ratio for 2006 should be treated with caution however as at an early stage of development Last 2 years it is significantly above 100% suggesting unprofitable Consideration of non-claim elements (expenses, investment income highly unlikely to compensate for loss ratio > 100%) But potentially a large claim in 2005 distorts numbers Trend in loss ratio appears to be upwards Since this is associated with increasing premium volume this is a particular concern Might be growing book by offering lower rates Or trying to expand book in soft market Or antiselection / competitor rating Claims made features Business written in early years might be from clients moving from loss occurrence to claims made In this case early years might have low exposure to claims (due to slow emergence of claims so few claims reported which do not trigger prior insurance) As account matures there is a full pool of earlier years generating claims so greater number of claims trigger claims made policy If these features are not appropriately allowed for in the pricing, a worsening profitability trend might be observed Further information Need further information before any strong conclusions Knowing the reinsurance structure for the class and the reinsurance spend/ recoveries in past is crucial Net loss ratio could be much lower due to e.g. excess of loss protection But if this is the case reinsurance premium likely to increase in future Need benchmark profitability requirement e.g. X% ROE over market cycle Must estimate the capital required for business Taking account of diversification Investment income estimated e.g. based on mean term from payment pattern and interest rate Expenses investigation required At least estimate of expense ratio Page 6

113 Subject SA3 (General Insurance Specialist Applications) April 2008 Examiners Report Ideally split of expenses into constituent parts Fixed/variable etc. Estimate claims handling costs Commission level unknown (assuming premium is gross of commission) Rate change information / rate adequacy on new business Further information on large claims Need discussion with underwriter of account and claims handler of account in particular to understand drivers of poor performance in 2005 Credit terms for premium Tax rate Monitor attachment/limit profile Mix of business change e.g. territory, industry Consider position in market cycle More detailed exposure information (e.g. terms and conditions) Split of business into new/renewal Undertake full profit testing exercise Benchmark against competitor loss ratios (if possible) Any reasons for running a loss leader, e.g. need to offer product to secure profitable business on other lines Investigate any changes in legislation Number of claims triangulation this would assist in observing separate frequency / severity trends Comments on Question 1(viii): Candidates generally scored well on this question, with the better candidates considering the potential impact in performance of changing from claims occurring basis to claims made basis in Most candidates showed that although results appeared poor for the last two years, more information was needed to put this in context. Some candidates suggested that a reason for the good results in the first two years was because of having a choice of who to claim from, i.e from the current claims made insurance or previous losses occurring. This is highly unlikely as a retroactive date would be used to avoid overinsurance. 2 (i) Some of the classes of insurance will have seen claims experience change in character over the last ten years because of the company s expansion. Others will have only been subject to moderate change. If there have been no claims, it will be difficult to allow for changes in exposure Commercial Fire The number of sites has increased by over 50% over the past ten years, implying that the latest claims experience arising from exposure now may be very different to that of ten years ago. There may have been a number of site sales and acquisitions over the period, adding further exposure changes and therefore impacts on claims experience. There may have been changes in other risk factors. Example of other change in risk factors, e.g. age of buildings different Page 7

114 Subject SA3 (General Insurance Specialist Applications) April 2008 Examiners Report As the business has expanded, productive use per unit floor space has most likely increased. Need to consider the number and amount of gross losses per location over period And sum insured Review of sum insureds over 10 year period Consider relevant rating factors Key aspect in the past claims experience will be whether or not any large single fire losses have occurred during the past ten years. Unless the company has been unlucky with large losses during period, the claims experience will most likely be very low and not take into consideration the additional premium to charge for expected large losses. Do any market statistics exist on much greater size portfolios of similar exposure mix with more credible large loss experience? Is the cost of small claims abnormally low? If it is then justifies a lower premium rate Are there particularly good safety procedures in place? Does the type or age of construction of the buildings warrant a lower or higher premium than a traditional book rate? Change in socio-economic factors Business Interruption A loss of this kind is only likely to occur after a major or total loss as the company may well now be potentially large enough to have business continuity plans in place. Therefore premium may look high in relation to past claims Furthermore, if a claim does occur now, it is likely to be much greater now than it would have been ten years ago because of far greater output. Existing claims experience is unlikely to be adequate to be able to use in isolation for assessing a suitable premium rate. Specialized machinery requiring a long lead time for replacement could increase potential risk. Exposure measure turnover / profit which could be volatile Consider relevant rating factors Employers Liability If the exposure available was over a long period, with stability in numbers of employees and working conditions, the company s own experience may well be a good guide for small claims E.g. payroll may be used as an exposure measure. Analysis of clerical versus manual payroll Consider relevant rating factors However, regard must be made to the chances of unsuspected industrial disease claims such as deafness or vibration white finger. 10 years is insufficient to establish the potential for such latent claims It may also be necessary to allow for the presence or absence of any abnormal claims or accidents to several employees at the same time. Changing environment and technological progress may also have an impact on claims experience. Page 8

115 Subject SA3 (General Insurance Specialist Applications) April 2008 Examiners Report Awareness of health and safety issues might have improved claims experience Greater productivity per employee may imply a higher real salary than ten years ago, as more responsibility is placed on individuals. This may result in much larger claims now than ten years ago. Public Liability Exposure measure turnover Consider relevant rating factors This is likely to cover mainly premises risks. Also external factors such as environmental exposure The number of premises has doubled over the past ten years and with floor space increasing and potentially a greater number of third parties visiting each premise, the experience now will be very different to that of ten years ago. Changes in internal environment may impact on claims experience. Claims experience may have been very light during the ten years particularly for large losses. It will be important to analyse trends in claims experience compared with the number of premises or other exposure measures such as turnover. Goods in Transit Acceptable exposure measure e.g. sum assured Consider rating factors e.g. distance travelled, frequency of travel, hub in travel, methods of transport Lots of new premises might mean more internal shipping rather than external shipping Past experience should be a reasonable guide unless rating factors have changed significantly Fleet Vehicle year as exposure measure Consider relevant rating factors The experience over the past ten years should be a good guide as the workforce has been stable and therefore the number of vehicles should be broadly similar. Key issue will be how the mileage per driver has changed over the past ten years. Are vehicles travelling much greater distances now as a result of road improvements or has the company been using alternative forms of transport such as rail, shipping or air? Has changed manufacturing processes impacted on the type of transport used? Ideally consider losses broken down into vehicle type Are larger vehicles being used now compared to ten years ago? Different drivers to previous years Need to consider losses split into physical damage and bodily injury due to different level of inflation Large claims will need to be truncated at a certain level to remove abnormally large claims with suitable adjustment for a long term allowance for large loss derived from a number of year s data within the premium rate calculation. Page 9

116 Subject SA3 (General Insurance Specialist Applications) April 2008 Examiners Report General consider for all products Claim frequency Average severity Analysis by cause Analysis by year Trends on all the above Comments on Question 2(i): This question was poorly answered. Few candidates considered the context of the question. Many did not answer the question being asked, instead deciding that this was asking for an explanation of how to conduct a pricing review. Better candidates demonstrated an understanding that each class of business would exhibit differing experience in losses and exposure during a period of rapid expansion with a stable workforce. (ii) A captive is an insurer wholly owned by an industrial or commercial enterprise and set up with the primary purpose of insuring the parent or associated group companies and retaining premiums and risk within the enterprise / form of self insurance Some captives are set up with the primary purpose of selling insurance to the customers of the parent. or alternatively they may insure other non Group companies if they have the expertise Comments on Question 2(ii): Bookwork question. Better candidates identified that the captive could sell insurance to customers of Rapidco or other non-related companies. (iii) Advantages Rather than passing insurance profits onto external insurers, the company retains these. This could therefore further improve the profitability of the group s accounts on a consolidated basis Could also benefit from further profits by selling products to customers of the company e.g. warranty Promotes greater awareness to senior management of managing risk within the company rather than passing to an insurer. A captive may pass on good experience and risk management improvement savings through lower premiums quicker than an external insurer Direct access to reinsurance markets and expertise. Or obtaining cover that cannot be obtained by a direct insurer. Assists in negotiating desired cover, terms and conditions with reinsurers There may be tax advantages if located in certain domiciles, e.g. Bermuda, Channel Islands Reserves/premiums are built up as pre-tax profits Reduces insurer credit risk exposure Could select against insurance market by increasing retention in captive when in hard market Page 10

117 Subject SA3 (General Insurance Specialist Applications) April 2008 Examiners Report Disadvantages Ties up the group s capital so potential conflict of opportunity cost of captive versus alternative better returns in group activities Increased volatility in group results dependent on reinsurance retention levels i.e. lack of risk-transfer Costly and complex to set up and subsequent running costs May pull management time and resource away from main Group activities. Location may be a factor here. Might not have the economies of scale of an external insurer so may overall be more expensive even though not giving away profit margin Accumulation of risk Comments on Question 2(iii): Bookwork question, generally well answered by most candidates. (iv) Capital requirements This will depend upon whether the subsidiary is to be restricted to the manufacturer s group business or not. If it is restricted, the need for capital may be fairly low since this selfinsurance arrangement is basically equivalent to internal group accounting. Although the actual capital requirements will depend on the domicile of the captive The statutory minimum requirement is required as long as the parent realises that it must subscribe more capital in order to maintain the minimum at least at every year end for the purposes of declaring financial accounts to the regulators and shareholders. If the company is to be seen as an independent trading entity which is accepting business from elsewhere, then it needs enough capital to show the level of solvency margin expected of other insurers. This will almost certainly be greater than the statutory minimum requirement. Capital and solvency levels will be a critical factor in the captive s ability to attract business as a measure of its security to meet claims as they fall due. The regulators of the country in which the captive will be set up may also demand a far greater level of security for independent policyholders The parent will need to balance the capital employed against return achieved against the alternative use of capital within the manufacturing company. Consider changes in future solvency regulation. Generic capital points e.g. volumes & growth initial costs adequacy of premium rates use of reinsurance expected volatility adequacy of reserves investment strategy Page 11

118 Subject SA3 (General Insurance Specialist Applications) April 2008 Examiners Report Reinsurance programme The reinsurer will require full details of all the group insurances it will write in order that it can rate them. Setting the level of retention will be important a lower retention will attract increased claims supervision by reinsurers.. as they will want to ensure that adequate risk management procedures are in place to limit claims in size and volume. The company may wish to purchase reinsurance initially to benefit from technical assistance and to provide financial support. The costs in providing reinsurance for this captive may be prohibitive if it is small in relation to other insurance companies who have greater purchasing power. It might be very difficult to place proportional reinsurance since the company could write business at artificially low premiums in agreement with the holding company.. with all subsidiaries being then required to pay supplementary premiums if necessary. If the captive could persuade reinsurers that it was rating risks on standard market rates and underwriting correctly, it might obtain reasonable terms. Its requirements would then be fairly standard, e.g. Surplus treaty for commercial fire and business interruption Excess of loss for motor, liability and goods in transit Quota share outward/inward with other insurers/captives may also be an option to reduce claims volatility and reduce accumulation of risk Catastrophe excess of loss to reduce exposure to concentration of risk in one area (all property and casualty covers) Generic reinsurance points e.g. Consider the group s overall risk appetite Consider what reinsurance is available and the cost including possible profit-sharing arrangements Consider alternatives to reinsurance available, e.g. more capital from parent. Consider net impact on capital requirements Consider security status of available reinsurers. Fronting could be used by captive if convenient or cost-effective Comments on Question 2(iv): Although reasonably well answered, most candidates missed marks for identifying the differences in capital requirements between open and closed captives. A number of candidates discussed in detail the current UK regulations on capital and Solvency II when the question clearly states that the captive will be set up in a non EU country rendering these comments largely redundant. Few candidates discussed the pros and cons of setting the desired reinsurance retention limits. There was a tendency to concentrate on general capital and reinsurance points rather than considering the specific issues for the captive. Page 12

119 Subject SA3 (General Insurance Specialist Applications) April 2008 Examiners Report Comments on Question 2: This question was based on a question from an early 90 s exam paper as was coincidentally an ActEd assignment. Very few candidates who may have done the assignment appear to have benefited from this. END OF EXAMINERS REPORT Page 13

120 Faculty of Actuaries Institute of Actuaries EXAMINATION 22 September 2008 (pm) Subject SA3 General Insurance Specialist Applications 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 both 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. SA3 S2008 Faculty of Actuaries Institute of Actuaries

121 1 You are an actuary working for a large, diversified insurance group based in the UK. You have been recently transferred to the Megarisks Division (MAD). MAD writes high layer product liability insurance. It accepts business via the slip system in the London Market. It tends to take large lines on the policies it writes, and does not participate on policies with excess points less than 100 million. The policies cover a range of major multinational companies. The director of MAD has asked for your assistance. Like you, the director has only recently transferred to MAD. He previously managed the UK household property division, and has no experience of product liability business. The director would like to understand more about product liability insurance. (i) Define product liability insurance. [1] (ii) (iii) Give an example of a claim that could be covered by an insurance policy written by MAD. [1] List the main factors MAD would be likely to consider when assessing the risk under each policy, stating why each factor is relevant to the risk. [9] MAD started writing business in The written premium, paid and incurred losses for each underwriting year as at 31 December 2007 are summarised below. Amounts are in millions. MAD does not purchase reinsurance. Underwriting Year Written Premium Paid Claims Incurred Claims There is only one claim for which a reserve for indemnity is held. This claim is on the 2003 underwriting year and was reported during (iv) (v) Describe the claim characteristics of the product liability business written by MAD. [4] Describe how you would produce a best estimate of unpaid claims for this business, in respect of all underwriting years as at 31 December Both discounted and undiscounted estimates are required. Note that you are not required to produce an estimate, but rather to describe how you would go about producing one. [19] SA3 S2008 2

122 The director of MAD has told you that he does not want the reserves to deteriorate. He would like to understand how confident you are that the actual unpaid claims will be no more than your undiscounted best estimate. (vi) Outline points you would make in a meeting with the director regarding: (a) (b) The requirements in GN12 for an actuary to comment on uncertainty in a formal report. The likelihood of future claims payments for this portfolio differing significantly from the estimated undiscounted reserve. [7] The director is keen to monitor changes in the adequacy of premium rates in the portfolio. (vii) Describe ways in which you could monitor changes in the adequacy of premium rates from 2007 to 2008, commenting on the practicality and likely effectiveness of each. [16] The director has recently read an article about insurance-linked securities (ILS). He is considering creating a bond which could be sold to the capital markets, which would provide funds to MAD in the event of a deterioration in the reserves. (viii) Comment on whether the director s plan is likely to be viable for MAD, including a recommendation to the director on whether to proceed. [5] [Total 62] SA3 S PLEASE TURN OVER

123 2 Quote-u-online is a new UK general insurance company that has recently been set up with the aim of selling personal lines insurance direct to the UK public exclusively through the internet. The company will advertise in newspapers, on television and the internet and will also be included on all the major price comparison websites. All quotes given and claims notified will be through online screens only. Telephone support is only offered to sales and claims enquiries. The company s underwriters devised the premium rating structure and rating levels. At the time of the launch, the Chief Executive (CEO) has asked you, as a consulting actuary, to explain the areas of uncertainty that may exist within the premium rates. He has not shown you the proposed premium rates but asked for your report to focus on the issues rather than the proposed rates. (i) Discuss the matters that you will need to cover in your report, with reference to the main products that are likely to be sold. [18] It is now two years since the launch and the company has been successful in acquiring business, especially in the private motor account. The CEO has requested that you provide an independent assessment and report of how profitable the current private motor account is. You will be given access to whatever company data you require. However, the CEO confides in you that he believes that the information from the company s case estimators is of little use. (ii) (iii) Explain what GN12 requires you to include in your report in respect of information and data you use. [5] Describe how you would produce such an assessment assuming that the case estimate information is of poor quality. [15] [Total 38] END OF PAPER SA3 S2008 4

124 Faculty of Actuaries Institute of Actuaries Subject SA3 General Insurance Specialist Applications EXAMINERS REPORT September 2008 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 December 2008 Comments Individual comments are shown after the solutions to each part question that follow. Faculty of Actuaries Institute of Actuaries

125 Subject SA3 (General Insurance Specialist Applications) September 2008 Examiners Report 1 (i) Define Product Liability Insurance Insurance that indemnifies the insured against legal liability for death or bodily injury to a third party, or for damage to property of a third party, that results from a product fault. Comments on Q1(i): This definition question was generally well answered, although a disappointing number of candidates simply regurgitated the question with some form of This offers cover for liabilities arising from products without mention of the nature of the liabilities and many did not mention third party. (ii) Example Loss Possible examples include faulty motor components causing a large number of motor accidents, pharmaceutical product liability relating to a widely distributed medicine, or failure of a single very expensive product (such as an industrial turbine). Many other examples are possible, but the example should be extreme enough to potentially produce losses excess of 100 million, and be within the scope of product liability insurance. Comments on Q1(ii): The majority of candidates correctly identified that the company in question wrote only at very high attachment points and gave an appropriate example (most frequently a pharmaceutical claim) although some candidates did miss the point of the question giving examples of events that would be unlikely to lead to any claims of a remotely high enough order of magnitude. (iii) Rating Factors Nature of product/industry type Certain products tend to experience a higher frequency and severity of losses, e.g. stationary manufacturers would tend to have a lower loss potential than pharmaceutical companies. Turnover or payroll Requires high turnover to pose a realistic risk to the high layer Geographic location of sales and geographic location of manufacture and related quality control laws E.g. litigiousness in the US / separate US and non-us turnover figures may be requested Latent claims / amount of the product already sold and used Packaging instructions and reason Subjective factors are also likely to be considered by the underwriter, e.g. his understanding of the insured s risk management systems. Claims history may be considered Possibly using a lower claim threshold However, claims history will frequently be limited, or of little relevance to the current risk environment. Consider claims history of similar companies Page 2

126 Subject SA3 (General Insurance Specialist Applications) September 2008 Examiners Report Limit/line/excess Attachment points impact likelihoods of claims / large claims Whether cover is on a claims made or losses occurring basis Whether a sunset clause is included and/or RDI. Writing business on a claims made basis/with a sunset clause allows the final underwriting result to be determined more quickly Under occurrence business, new claim notifications may be received many years after the policy has expired. Whether losses can be aggregated by event Whether there is an aggregate deductible Level of aggregation with that risk and the rest of MAD's portfolio Treatment of legal expenses (excluded, included in addition to limits, included within limits) Comments on Q1(iii): Candidates almost invariably identified such key factors as the locations sold and type of industry/products produced, although many went into extensive detail on the industry/product type while missing other key aspects of the risk such as the policy terms or attachment points. (iv) Claim Characteristics Liability claims tend to be long-tailed, i.e. claims may take many years to be notified. The slow notification is likely to be a pertinent feature of MADs experience as products that have continued to be used for a significant time before discovery and notification are more likely to hit the excess point If MAD writes policies on a claims made basis this will affect the development profile of the risk, depending on the time limits for reporting Case estimates are often highly uncertain. Uncertainty in respect of reported losses relates to the existence of liability as well as its quantum Settlement can be a lengthy process involving legal action, particularly for claims of this magnitude Claims are heavily affected by legislative changes. There may be issues that lead to claims purely on this basis. Claims are heavily affected by inflation, including general, wage and court award types, and inflation is heavily geared for MAD as it is an Excess writer The outcome of the settlement process might be that the insurer is not liable for the claim, e.g. because it is not covered by the policy, or because the final claim is below the excess point of the layer. However, the insurer would likely incur legal and other costs in handling some of the claims received, even if no indemnity is ultimately payable. The majority of claims hitting MAD's excess point are likely to be the result of catastrophes and accumulations Re-opened claims. Latent claims can be an issue, with claims often not noticed for a while. Payment characteristics - periodic / lump sum Litigiousness MAD s claim frequency is likely to be low because few claims would be expected to exceed the high excess points at which it writes. Page 3

127 Subject SA3 (General Insurance Specialist Applications) September 2008 Examiners Report MAD s claim severity is likely to be high as if a claim reaches the high layers insured it is likely to be very large. The data given for MAD appears to be consistent with low frequency, high severity claim experience, and losses taking several years to settle. Comments on Q1(iv): Candidates generally scored well on this question, although the number of potential points available was well in excess of the maximum mark leaving a high score comparatively easy to obtain. (v) How to produce a best estimate of unpaid claims Review of Outstanding Claims The 30 million outstanding claim requires separate analysis. Investigations could include discussion of the claim with claim staff, discussion with other experts such as underwriters, and review of legal or other expert opinions that have been obtained by the company. Consideration may be given to the overall market loss with MAD's exposure then worked out as a proportion depending on the line size and attachment. points. The loss is unlikely to settle for the current case reserve and may settle higher or lower. General Analysis The actuary should meet with underwriters and claim staff to understand the business written in more detail. Review previous reserving methods and assumptions. Data splitting / portfolio segmentation Split of Exposure by country/region/currency Split of Exposure by industry/product type Split of Exposure by size of insured Split of Exposure by limit/excess The characteristics of the portfolio may have changed over time (e.g. change in mix of business), and such features should be understood. Premium changes and reasons It is necessary to understand how the underwriters price the business. The premium written has varied from year to year. It would be useful to understand the reasons for this. How much of the change is due to increases in the size of the portfolio. How much is due to a change in mix of business. How much of the change is due to the insurance cycle. Additional data, particularly lower layer information The underwriters or claims staff may be aware of potential claims which are not included in the outstanding claims data. E.g. they may have been notified by the broker of losses on lower layers written by other insurers, which are considered to have the potential to deteriorate to higher layers written by MAD. Techniques such as extreme value theory could be used to estimate extreme values from a limited data set. Page 4

128 Subject SA3 (General Insurance Specialist Applications) September 2008 Examiners Report This could be used in conjunction with a stochastic method to estimate the potential excess losses based on the lower layer experience. Loss curves used in underwriter rating guides could also be used to adapt low layer experience to an estimate of MAD's exposure Specific IBNR estimates can be produced in respect of such losses. There may be awareness of industry/product types that require separate analysis, because there is considered to be a particular risk of claims. Policy wording (e.g. sunset clause) may mean that no further claims are possible on some of the older underwriting years. For such years, reserves would only be required for reported claims, and the required reserve may be nil. Projection methods Limited claims data means it is not possible to apply standard projection techniques such as chain-ladder to the account. It would be useful to apply a number of different methods to estimate unpaid claims. Techniques based on initial expected loss ratios could be used, e.g. the Bornhuetter-Ferguson method. Loss ratios used would need to reflect the insurance cycle. Frequency-severity modelling A frequency-severity model (or average cost per claim model) could be constructed. Although even at the lower layers claims data are unlikely to be sufficient to accurately parameterise this. Exposure based methods An exposure based method based on the underwriter's rating model could also be used. This would involve rating each risk individually against a rating model assumed to produce a particular loss ratio and aggregating the data to portfolio level. The capital model may also provide some estimates of claims levels. E.g. the models may contain information on pricing and loss assumptions. External data sources and benchmarking relevant internal data from other areas of the business cedant/policyholder data industry data/benchmarks data from regulatory returns reinsurers data: must specify that it is parent group's reinsurance as MAD doesn't purchase expert judgement engage external expertise (e.g. consultants) rate change indices External benchmarks might not be representative of this portfolio, and so require adjustment before they can be used. Page 5

129 Subject SA3 (General Insurance Specialist Applications) September 2008 Examiners Report It may not be possible to objectively adjust the data so some subjective assumptions will be required.. Discounting Benchmark payment patterns could be used to discount claims. Various legislation will affect this depending on the purpose Discounting rate should be set with reference to the investment returns achieved Comments on Q1(v): This question appeared to trouble many candidates who clearly felt uncertain how to proceed when standard statistical methods were not practical due to a lack of claims experience, although the majority of candidates at least correctly identified that statistical methods were not practical and many were able to suggest sources of information that could help the actuary to produce an estimate, for example, benchmarks or expert advice. Better candidates considered methods such as review of lower layers experience or stochastic modelling. A surprising number of candidates however failed to make any comment about what the actuary might do with the data already available to produce an estimate, in particular review of the single existing claim which would be a natural first step in any such claims review. (vi) (a) GN12 Uncertainty Requirements The report should normally indicate the nature, degree and sources of uncertainty surrounding the results and sensitivities to key assumptions. Uncertainty should normally be quantified where practicable, but otherwise should be reported using an appropriate descriptive summary. If there are specific features of the business that present potential concerns or significantly increase the uncertainty of the results, beyond that which an informed reader of the report would reasonably expect, then this fact must be clearly highlighted in the corresponding reservations or limitations of scope, included in the report. If there is a substantial probability of material adverse deviation from modelled results, attention should normally be drawn to this in the report. (b) Uncertainty in this portfolio The claim characteristics of the business written are such that the difference between the actual unpaid claims and the best estimate unpaid claims may be large. It would be impossible to hold large enough reserves to guarantee no adverse deviation as claims can effectively be unlimited. In any case, accounting regulations may prevent such a reserving policy. The expected claim frequency for high-layer product liability business is low, which makes the overall claim numbers significantly more volatile than more attritional business.. Page 6

130 Subject SA3 (General Insurance Specialist Applications) September 2008 Examiners Report If the portfolio written is concentrated in certain areas the uncertainty in the reserves is increased. E.g. concentration risk may occur if a large number of assureds make similar products, or very large limits are written for some assureds. (Or other relevant example.) Any deterministic reserve estimate only gives limited information for an account of this type and a stochastic approach would give a better indication of the scope of the volatility. Individual claim sizes are uncertain, and can be very large. This means that a single claim could have a very large effect on the liabilities of MAD. The high attachment point means that a small variation in the ground up claim amount will have a disproportionate effect on MAD s liability. It may be possible that no payments are ultimately required on the outstanding claim. This could mean that the estimated unpaid claims are overstated. Because MAD does not purchase reinsurance any improvement or deterioration in the claims will be entirely for the account of MAD, rather than possibly being shared with reinsurers. Comments on Q1(vi): In spite of GN12 featuring regularly in SA3 exams and knowledge of professional guidance being a critical requirement for qualification as an actuary, many candidates displayed only the most basic grasp of the requirements set out for commenting on uncertainty. The most common error was to go into extensive detail about tailoring communication to the audience involved. Many candidates also missed the point of the second section, commenting in great detail about aspects of general product liability while failing to comment at all on the uncertainty and volatility caused by such high attachment points. (vii) General comments It should be noted that premium rating on this account is necessarily subjective. As a result of this subjectivity, any method of premium rating will be approximate. Year to year premium comparisons For stable portfolios, the overall premium can be compared from one year to the next Alternatively, for risks written in both 2007 and 2008, compare the premium charged in each year to get a risk level movement and aggregate it to portfolio level. These approaches are simple and practical but require reasonable levels of stability in the portfolio. The methods will not pick up the effects of new and lost business. Page 7

131 Subject SA3 (General Insurance Specialist Applications) September 2008 Examiners Report If a material proportion of the portfolio is stable one can use movements on the renewing element of the business as a basis for estimates of movements on new and lost business. These methods become more useful the more stable the business is. Adjustments for exposure changes for year to year comparisons When looking at movements on individual risks, policy conditions such as limits and deductibles will almost certainly change from year to year, and the effect of such changes on rate adequacy will need to be considered. A table of increased limit factors could allow the effect of such changes to be quantified. Such tables could be applied simply, but may not be accurate. The nature of the risk insured will change from year to year. E.g. the insured s turnover may increase, or it may start manufacturing new products (or other example). Allowances for the effect of such changes on rate adequacy may rely heavily on judgement. Rate-on-line comparisons An index could be produced showing rate-on-line or some equivalent measure charged in 2007 and There may be issues in producing this measure where liability is unlimited; and for business at these attachment points such a measure is often of limited value This index could consider both new business and renewals. Separate indices would need to be produced for different rating cells, since a different rate-on- line would be charged for different types of assured, so a change in mix of business could distort the calculation. Such indices could be produced relatively easily from a detailed policy database. It may not be possible to fully remove heterogeneity from the data without reducing the credibility in each sample. Pricing tool / individual risk pricing Underwriters may use a pricing tool to assist them in pricing risks. A pricing tool/software could be produced to give an indication of the technical price for each risk. An estimate of the technical rate might be produced by a pricing actuary for each risk. To monitor rate adequacy, the actuary could compare the rates actually charged to an indicated technical rate for both 2007 and 2008 underwriting. It may only be practical to apply this to a sample of policies. This method could consider both new business and renewals. The indicated technical rate should allow for rating factors such as excess, limit, industry type and size of insured, so the rate change produced should be sensitive to changes in the mix of business in the portfolio. However, the indications of technical price may not be accurate. This process may also be expensive. Page 8

132 Subject SA3 (General Insurance Specialist Applications) September 2008 Examiners Report Subjective underwriter comments The underwriter could be asked to comment on the change in rate adequacy in the portfolio. This approach makes use of the underwriter s expertise. The rate change indication is quick and easy to obtain. The underwriter may be able to quantify the effect of variables that are difficult to capture in a model, such as changes in the overall risk environment: e.g. changes in propensity to claim Legislative changes Changes in coverage e.g. costs in addition Or movements in the insurance cycle / changing levels of competition etc. It is difficult to judgementally allow for all the factors that could have an effect on rate adequacy. The results of this approach may be difficult to verify for auditors, reinsurers, management and others who are interested in rate adequacy. This could, however, be a useful check on the results of other methods. The underwriter s assessment may potentially be subject to bias (which could be introduced intentionally or unintentionally). Other miscellaneous factors Underwriting file review/ peer review. Portfolio movement analysis may highlight areas where rates are out of line with the market, and identify specific areas to focus on Claims inflation will affect rate adequacy. Because of the high attachment point the effects of claim inflation will be highly geared Appropriate indices of prices should be monitored to allow an adjustment to be made. Examples of other factors that could affect rate adequacy include: Changes in tax rates Changes in expenses Changes in commissions Compared to the adequacy of technical rates, the allowance for such factors will typically be relatively straightforward. Comments on Q1(vii): This question was extremely poorly answered by the majority of candidates. Most candidates amazingly made no reference whatsoever to such absolute basics of rate monitoring such as looking at changes in premium or exposure from one year to the next. A number of candidates made very confused comments about monitoring the insurance cycle to find out what was happening with rates rather than considering how they would review their own company s data to find out the changes within their own portfolio. Page 9

133 Subject SA3 (General Insurance Specialist Applications) September 2008 Examiners Report (viii) Insurance-Linked Securities (ILS) A more usual type of ILS is a catastrophe bond, which the market is likely to have more appetite for Under these, if a defined index is triggered, the bondholders typically forfeit the interest and principal on the bond to the insurer. Unlike catastrophe bonds, the trigger for the ILS in this case is unclear. It would be difficult to construct an objective method of establishing the required change in reserves for this account. Capital market investors may therefore be reluctant to buy the securities because of the moral hazard. Also, because this is an unusual type of bond, the expense of structuring and marketing the security may be especially high. May be difficult to persuade capital markets to invest in risks where standard quantification tools have not been developed. Capital markets may also demand a higher return because this is an unusual type of risk with which they are unfamiliar. However, this risk may provide diversification from other assets in investors portfolios. The portfolio written is fairly small, so the costs of an ILS may be prohibitive..investors would probably want MAD to maintain an interest in the reserves, so that claims are managed properly. There may be alternatives that better meet MAD s need, e.g. an internal reinsurance within the group, or conventional external reinsurance. Use of SPV would mitigate counterparty risk. Another alternative could be to purchase adverse development covers. Adverse development covers written in the market typically protect against losses above a specified percentile. Although issue of an ILS for MAD would be possible in theory, it is unlikely to be viable in practice. The director should be advised against proceeding with a capital markets solution at this time. Comments on Q1(viii): This question was generally reasonably well answered. Many candidates correctly identified the key issue of the trigger for the ILS not being a clearly defined and objective index and were able to provide an appropriate recommendation to the director and the reasons for their advice. 2 (i) General comments on internal & external data No historical claims experience on which to base premium rates. Where benchmark data have been used there will be uncertainty as to the quality of the adjustments made to them. Has it managed to recruit good quality underwriters and are they basing premium rates solely on those of its competitors? Internet/distribution method factors The level of moral hazard associated with Personal Lines business may introduce a level of uncertainty to the premium rating. Moral hazard risk is increased for an internet channel as it is easy to just adjust quote inputs to get different quotes out e.g. what if I said the car was in a garage overnight? Page 10

134 Subject SA3 (General Insurance Specialist Applications) September 2008 Examiners Report Marketing/brand risk from site crashing or if it takes too long to get a quote. Risk of expenses being greater than expected due to handling lots of telephone calls from internet referrals. Potential impact on fraudulent claims from economic downturn. Risk of antiselection if entering the market with less sophisticated rating structure than competitors. This is a potentially serious issue due to the level of referrals from aggregator sites which naturally highlight underpriced areas of the rating structure. Motor Volume is a key factor. If the company writes too little business, the fixed expenses allowed for in the premium rates may not be recouped. Persistency is also critical in the longer term as renewal expenses will be smaller compared to initial expenses as well as broker market costs built into their premium rates. Claims experience is usually not very volatile with the exception of very large individual losses. Antiselection because of the poor rating structure is a more critical issue for motor business than for others The impact of investment returns is not a critical issue as motor mainly consists of short tail damage claims with usually a smaller amount of longertailed liability claims. Claims inflation is a material issue for the bodily injury claims. Household As with motor, volume is a key factor. Household business tends to have better persistency than motor so may have more difficulty breaking into this market with established players and a sizeable market attached to the building society/mortgage channel. Customers who regularly shop around direct through aggregator channels may result in a lower persistency level once business is gained. There is greater uncertainty from year to year on claim amounts than motor due to more of the claims being linked to uncertain weather conditions such as: freeze leading to burst pipes storm damage to properties flood damage to properties long, dry summer leading to subsidence There are fewer critical rating factors compared to motor (location and sum insured being the most important) and therefore less uncertainty from the rating structure. As this is generally a short tail class, investments are not a major issue. Rebuild costs may be linked to inflation, so can be a significant risk For both classes, the use of excess of loss and catastrophe reinsurance will help limit some of the uncertainty in the claims experience. However this will be at a cost. Page 11

135 Subject SA3 (General Insurance Specialist Applications) September 2008 Examiners Report Risk that notional sum insured used in rating engine for household quotes is incorrect Other classes Other main personal lines classes of business that the company may be writing include: Travel Pets Creditor Personal Accident Warranty The premium rating structures of these products are usually less sophisticated with all insurers using broadly the same rating factors. Claims are for relatively small amounts and are usually very short tailed. Medical inflation (for Travel) and vets fees inflation (for Pets) are potential areas of uncertainty as recent trends have shown an increase in these. Expenses Amount of expenditure on acquisition can be controlled by the company. However volumes of business emerging from the advertising are highly uncertain. So expenses per policy are often very difficult to predict. The total level of expenses may differ from the amount assumed in the business plan. For example, the cost of hiring staff or obtaining premises may exceed expectations (or other example). The insurer may not be able to raise premiums to cover expense inflation due to competition in the market. Assessing the level of uncertainty with respect to volumes of business Need to consider trends in methods of buying and selling insurance. The stage in the insurance cycle will affect the volumes of business that these particular rates will generate. Current and likely future trends between the high street broker market, telesales brokers and internet operations need to be forecast. Assess the current number of internet based operations and their financial position if known. Likely future number and size of internet based insurers. The history of existing internet based insurers (how quickly they gained critical mass, how many have failed) Impact of premium rates on volumes Conversion rate is critical to volumes achieved. Conversion rate will be highly price sensitive due to method of sale. This will depend on the extent and speed with which the company revises its premium rates in response to experience. E.g. a company may find it can reduce its rates in a certain rating cell to increase conversion rate without impacting significantly on profit. Page 12

136 Subject SA3 (General Insurance Specialist Applications) September 2008 Examiners Report Other more generic Risk factors Reinsurance cost Mix of business sold, if profit not uniform between rating classes and products Changes in legislation Levels of crime 3rd party bad debt rates Propensity to claim Level of contingency margin appropriate for the company's attitude to risk Comments on Q2(i): Answers to this question were frequently disappointing with many candidates giving very generic answers more appropriate to an ST3 exam while completely failing to exercise any higher order skills. The first paragraph of the question set out a number of features of the company and their method of sale that were intended to steer candidates into giving consideration to particular uncertainties and issues that might arise from internet operations, although most candidates made little or no mention of internet issues in their answers. Candidates failed to give due consideration to the specific phrasing of the question which asked for the uncertainties within premium rates, commenting on such components of office premiums as taxes and MIB contributions which are readily available information that no credible insurer would be uncertain of. Also, relatively few candidates identified which were the key areas of uncertainty, and how the key areas of uncertainty varied between products. (ii) The report must indicate the sources of the data used and the extent to which the user of the data takes responsibility for data accuracy or completeness. The analyst may need to rely on or use the work of other people. If there is a risk of confusion as to the division of responsibilities between themselves and other persons or organisations, the respective responsibilities must be made clear in the report. The analyst must draw attention to any material limitations in the available data. In particular the company s case estimators. Including the effect on the appropriateness of the data of changes in the way the business analysed has been conducted. The analyst must make reference to limitations in the data that have materially added to the uncertainty surrounding the results of the work carried out. The report must describe the criteria used for subdividing data into groups Where the member makes adjustments to the data the nature, amount and rationale for the adjustments must be clearly stated. The concerns about the accuracy of the company s case estimators have materially added to the uncertainty Comments on Q2(ii): This question was generally well answered, although a number of candidates were only vaguely aware of some of the detail of GN12, which should be an essential part of any candidate s preparation for SA3. Page 13

137 Subject SA3 (General Insurance Specialist Applications) September 2008 Examiners Report (iii) The main emphasis at this stage will be on how well the company has achieved its planned loss ratio, i.e. estimated ultimate claims against earned premium. Other main factors Expenses Expenses incurred to date are likely to be very high due to development and initial running costs of the new company and this should be adjusted for to arrive at a long term assessment of profitability. Example of expense breakdown (loss adjustment, fixed, variable etc) Investment income Reinsurance cost Capital costs / profit margin / requirement etc Data issues The absence of good quality case estimates is an issue, primarily due to the difficulty in assessing the tail development of longer tail claims such as third party bodily injury. We only have 24 months of development experience and earned exposure in the initial 6 months will be very low, meaning the credibility of the paid development at the tail will also be questionable. The claims handling procedures would also likely take some time to stabilise. Earning patterns and run-off for the first few months would be unstable and this should be borne in mind in any analysis (any relevant attempt to correct for this) As the company has been successful, there may be more reasonable patterns of development from later months. It may be possible to use these to fix the run off pattern for the first accident year. If PD and BI are considered together then the resulting paid claims development will include virtually no third party bodily injury claims. Third party property damage claims may also be under-represented unless it adequately allowed for with a tail factor If they are considered separately then there will be little to no data at all for the bodily injury. Therefore the use of paid triangulations with chain ladder techniques alone may well under-project by significant amounts. Other methods will need to be used to determine appropriate levels for IBNR and IBNER on longer tailed claims. General data splitting Estimated ultimate claims will need to be calculated by subdividing the claims into homogeneous groupings of similar development profile. Splits are likely to be (in ascending order of tail) own damage, third party damage and third party bodily injury. If the data allow, it may be possible to separately analyse gross payments and recoveries received from third parties. Further sub-analysis may be taken between comprehensive and noncomprehensive business. Page 14

138 Subject SA3 (General Insurance Specialist Applications) September 2008 Examiners Report Accident month data should be viewed to determine if there are any trends emerging from the data. PD / BI data splitting One could develop own damage and third party damage separately, using any additional company or industry-wide data available to derive a suitable IBNR/IBNER. For bodily injury, an addition to the above could be applied by either: projecting bodily injury claim numbers to ultimate and then applying a market average cost of bodily injury claims recruiting or requesting a claims assessor to concentrate on coming up with a sensible estimate for each of these claims (as there may only be a few hundred) For the latter, it will be particularly useful in identifying particularly large potential outstanding liability claims as this could have a significant impact on profitability. Benchmarking Compare the loss ratio against other insurers in the market. Ensure that loss ratios are defined in a consistent manner e.g. treatment of claims handling Assess long term profitability by assuming similar loss ratios in the long term along with expected long term expense ratios, e.g. by considering the expense ratios of other insurers who are long established in the internet market, together with investment rates achievable. One possibility is to make use of market data to select a suitable tail factor. E.g. FSA Returns for a similar company or a similar set of companies may allow development factors of paid to ultimate to be derived. Miscellaneous key factors The mix of business (comp versus non-comp) A review of key exposures in the account may highlight areas of weakness / concern. The potentially different terms and conditions between insurers. Any changes to the rates and structure since the company started writing. Mix by source: the different claims handling procedures the actual mix of claims Exposure-based / BF type methods. An exposure-based approach could be used. This could involve taking projections from more developed accident months divided by associated earned exposure and applying this risk premium to more recent, less developed accident months. Bornhuetter-Ferguson methods could be used on the claims splits by taking initial assumptions about the loss ratios split between own damage, third party damage and bodily injury and split between comp and non-comp business Page 15

139 Subject SA3 (General Insurance Specialist Applications) September 2008 Examiners Report from the underwriters with credibility factors derived from a combination of internal development factors and external market or industry wide data. Case estimates It may be possible to look at a sample of case estimates to try to understand better what the problems may be with them following the CEO s comment. This may enable the case estimates to be adjusted to derive more reliable incurred claims figures. General comments In practice, a combination of methods is likely to be used to determine the expected profitability of the company. Other stakeholders e.g. underwriter, internal actuaries etc may have relevant information about the account. Making the company aware of the additional uncertainty in the results as a result of poor quality estimate capture could enforce better estimation in future. Comments on Q2(iii): As with question 1(v), candidates clearly struggled with a situation where standard statistical projection techniques were not ideal. As standard statistical techniques can easily be replicated with software packages, perhaps the most critical area of the actuarial skill set is the capacity to identify weakness in statistical methods and to exercise judgement in working around such difficulties, and this skill appears to be lacking in the majority of the candidates. Answers that simply listed a standard step by step account of a statistical projection method were common for this question, with few candidates giving due consideration to specific features of the question such as the fact that the company is growing (distorting the development pattern) or to methods by which they could compensate for the poor case estimates. It is not enough to just say use benchmarks/consultants or that someone else must know the answer. END OF EXAMINERS REPORT Page 16

140 Faculty of Actuaries Institute of Actuaries EXAMINATION 27 April 2009 (pm) Subject SA3 General Insurance Specialist Applications 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 both 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. SA3 A2009 Faculty of Actuaries Institute of Actuaries

141 1 The Republic of Merino is a developed country with a range of small, medium and large general insurance companies. Regulations currently require general insurance companies in Merino to establish claims reserves on a best estimate basis. Thus the claims reserves held by companies represent the mean of the range of possible future outcomes, without margins. Two years ago, one of the largest general insurance companies in Merino became insolvent. In response to public concern about the state of the insurance industry, the government has proposed new regulations. These would require general insurance companies to establish claims reserves that include risk margins. It is proposed that general insurance companies hold claims reserves equal to the 75th percentile of the range of possible future outcomes. Company A is a general insurance company writing private motor insurance. It has been writing this business for 20 years and is the largest insurer in Merino. Company B only started writing insurance one year ago. It writes only professional indemnity insurance. (i) Give an example of a method that is likely to be suitable for each of the companies A and B to estimate the 75th percentile risk margin, giving a reason for your choice in each case. [2] The government is keen to understand how general insurance companies are likely to view this proposal. (ii) (iii) Discuss the advantages to the general insurance industry of requiring insurers to hold 75th percentile risk margins. [9] Describe the concerns that the insurance industry may have with this proposal. [18] The government announces that it will go ahead with its proposals. However, general insurance companies will be allowed to choose the percentile risk margins that they wish to adopt. The adopted risk margin must provide a probability of sufficiency greater than or equal to 60%. General insurance companies must publicly disclose the percentile that they have adopted as their risk margin. (iv) Describe the issues that a general insurance company should consider when deciding the probability of sufficiency to adopt. [14] [Total 43] SA3 A2009 2

142 2 A small UK general insurance company writing UK and other European business wishes to expand its employers liability book of business. It is considering building a new rating model for this portfolio. The underwriter responsible for this portfolio explains that: he is the only underwriter for the employers liability book he has recently hired a junior assistant he sometimes uses a US workers compensation rating model that he was given five years ago as a guide to setting rates and relativities between different trades he has never possessed a rating model that he has trusted and does not believe that a rating model can be better than his own judgement his incurred loss ratios over the last ten years have been at a level that he believes has made money in every year except one (i) Explain the risks to the company of not building a new rating model. [12] (ii) Discuss the advantages to the underwriter of building a new rating model. [8] (iii) Outline the information that would be required to build the rating model, in particular considering the following areas: Underwriting Reinsurance Claims Finance [17] (iv) Outline the problems that might be encountered in building the rating model. [4] The company has had discussions with a UK based managing general agent (MGA) that specialises in casualty insurance. The MGA offers underwriting and claims handling services. It is looking for a general insurance company to provide capital by taking a coinsurance follow line on its portfolio of employers liability business through a binding arrangement. (v) Discuss the advantages and disadvantages to the company of taking a follow line on this coinsurance arrangement. [16] [Total 57] END OF PAPER SA3 A2009 3

143 Faculty of Actuaries Institute of Actuaries Subject SA3 General Insurance Specialist Applications EXAMINERS REPORT April 2009 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 2009 Comments Individual comments are shown after the solutions to each part question that follows. Faculty of Actuaries Institute of Actuaries

144 Subject SA3 (General Insurance Specialist Applications) April 2009 Examiners Report 1 (i) Example Methods Company A Any relevant example likely to be one of the standard stochastic methods. Relevant reason, e.g. company A likely to have good data or suggestion is a widely recognised method. Company B Any relevant example judgement, scenario analysis, or a statistical method applied to benchmark data. Relevant reason, e.g. company B has limited internal data or necessary to use judgement. Comments on Q1(i): This was generally well answered by most candidates, although some candidates did not suggest a method as requested in the question. (ii) Advantages of Margins Reduces the likelihood of holding inadequate claims reserves. Relevant examples where reserves might deteriorate. Should have a positive impact on credit ratings/share price support/attracts investors/international trade. This may make the general insurance industry appear more secure. This is an advantage to insurers. People will only buy insurance if they believe the insurer will be able to pay any claims. This is particularly relevant for Merino, as one of the largest general insurance companies has recently become insolvent The regulations would be likely to promote a greater use of stochastic modelling within companies. Although stochastic modelling would not necessarily be appropriate for every portfolio the proposals would require companies to give greater consideration to reserve uncertainty, thus increasing management awareness A greater understanding of reserve uncertainty will provide valuable information to managers (or other advantage of stochastic modelling) Consideration of reserve uncertainty may align well with other analyses undertaken by insurers, e.g. DFA, estimating capital requirements. Reserving above the best estimate is increasingly regarded as best practice. The insurance industry may consider it advantageous for local regulation to be in line with international standards. This will particularly be the case if local market participants also operate internationally. All companies are required to carry out these calculations - neutral to competition. Defer profits and thus defer payment of tax. Encourages more appropriate use of reinsurance. Makes benchmarking easier/consistency in the market. Page 2

145 Subject SA3 (General Insurance Specialist Applications) April 2009 Examiners Report Expected lower contributions to solvency protection fund. Better match to risk. Relevant example of a country where general insurance companies are required to hold risk margins, or such a change is proposed, e.g. Solvency II, Australia Comments on Q1(ii): A number of candidates failed to understand what a percentile is. (iii) Some companies may not have sufficient data to apply a stochastic method. Some companies may not have sufficient internal expertise to calculate the required estimates. External expertise may be expensive to engage or unavailable. Additional costs to companies in doing the calculations These additional costs would need to feed into premium rates with potential impact on level of sales. Risk margins are only one part of the regulations that ensure the solvency of insurers (e.g. operational risk, credit risk) Arguably it is the total amount of capital held by insurers that is of greatest importance, not whether the capital is held as free reserves or reserve margins Significant reserve increases can be difficult to explain to shareholders and/or other stakeholders However, an annual release of margins from prior periods would become expected. Some exposures are particularly difficult to estimate margins for, an example being latent claims. There are many approaches to calculating a 75 th percentile. Different methods can produce very different results. Different methods are appropriate for different lines of business. There is not yet general agreement among actuaries as to which is the best approach for a given class of business. Naive application of methods can provide misleading results.. From a regulatory perspective, it may not be possible to determine whether companies estimates really do represent the 75 th percentile. Increased regulatory costs will feed back to general insurance companies. Although it is also impossible to say whether a best estimate really is the mean of the distribution, uncertainty is greater for more extreme percentiles. It can be difficult to compare results between insurers, e.g. if company A has a lower margin than company B, it will be unclear whether this reflects the riskiness of the liabilities, method selection or a difference in judgement? (or other relevant example) Such uncertainty may undermine confidence in the insurance industry. Page 3

146 Subject SA3 (General Insurance Specialist Applications) April 2009 Examiners Report The assessment of diversification between classes of business is one of the more difficult areas. It is difficult to estimate correlations between lines of business based on observed experience. It is often necessary to use general reasoning to estimate correlations. Regulators may not have the necessary level of expertise and resources to review the risk margins estimated by general insurance companies. The calculations used to produce the risk margins may be difficult to explain to management. Other stakeholders may also be confused, e.g. policyholders, investment analysts. There may be a false confidence held by stakeholders. A 75 th percentile means there is still a 1 in 4 chance that reserves will be deficient. Capital requirements should be revised to be consistent with the new reserving requirements, e.g. if companies are required to hold capital to the 99.5 th percentile, then the regulations should reflect the fact the reserves are already at the 75 th percentile. If current capital regulations are set at a very low level, some companies may not have enough capital to reserve to the 75 th percentile. Companies may appear less solvent, since they are required to hold higher reserves. If reserves are overstated results may look worse than expected, and tie up assets that could be better used (increased costs of locking in assets, conflicts with growth/acquisition opportunities) Companies may be unhappy if the profits cannot be distributed until later (because profits are used to fund reserve margins) General insurance companies would be concerned that the new regulations result in a less favourable tax treatment. Tax and regulatory issues for insurance companies who already hold implicit reserve margins. Companies may reassess their mix of business in light of these regulations 75 th percentile may not be relevant for all classes of business Comments on Q1(iii): This was poorly answered by many candidates who failed to generate a broad range of answers for the number of marks available. The marks awarded for this section were generally low relative to the rest of the paper. (iv) General insurance companies would want to know the level competitors and other countries are adopting. Consider any views that have been expressed in the market, e.g. by regulator/government, rating agency, competitors, industry or professional bodies. Page 4

147 Subject SA3 (General Insurance Specialist Applications) April 2009 Examiners Report If most companies decide to hold 80%, a company holding 70% might appear unattractive to customers or other stakeholders (or other relevant example). However, stakeholders may be much less interested in reserving probability of sufficiency than other factors (e.g. policyholders may buy based on price). Companies would certainly want to hold at least the minimum specified by law. Consider uncertainty in best estimate and distribution of uncertainty to decide on level of percentile, e.g. if there is a greater than usual level of uncertainty in the reserves, companies may wish to hold a higher margin in order to increase the likelihood that reserves will be adequate. However, the financial cost of holding reserve margins at a higher level of sufficiency will be greater for the most uncertain liabilities. The cost of holding risk margins to a particular probability of sufficiency will also depend on the diversification within the portfolio. Insurers should not adopt extreme risk margins, e.g. 99.9%. Such percentiles cannot reliably be calculated for many classes of business. It would be damaging the general insurance company s reputation if reserves deteriorated beyond an extreme margin. As the selected percentile moves above the mean, the cost of providing for the risk margin increases significantly, e.g. it generally takes more capital to move from the 90 th to the 95 th, compared to moving from the 70 th to the 75 th. For some highly skewed distributions, the mean might be above the 60 th percentile, e.g. reserves for asbestos claims (or other example of a highly skewed distribution). It would seem imprudent to hold less than the best estimate reserves. The company should consider the link between reserve margins and total capital requirements. Consider the total amount of assets available and ability to raise capital. The company may be relatively indifferent about the precise split of assets between capital and reserve margins. The company may choose to minimise risk margins to increase the apparent level of capital. This may be attractive if investment restrictions apply to assets backing the free reserves and the reserve margins (or other relevant example). Alternatively there may be some tax or other advantage in adopting a higher reserve margin. The company should consider its tolerance for reserve deterioration. It is possible to imagine companies with a high degree of tolerance (e.g. certain privately held companies) (or other example) The company may have derived statements of its risk appetite as part of its broader risk management framework. Such statements may include a policy on tolerance for reserve movements, which would drive the decision on risk margins. Page 5

148 Subject SA3 (General Insurance Specialist Applications) April 2009 Examiners Report Consider whether reserves are to be held on a discounted or undiscounted basis. Undiscounted reserves will contain margins, so will correspond to a higher percentile of adequacy. Position in insurance cycle, particularly if percentage can vary year by year Opportunity cost of capital/other business opportunities. Benchmarks used by smaller companies may not be available for different percentiles. Consider mix of business (classes of business, territories). Cost and availability of reinsurance. Time horizon over which adequacy is assessed: the shorter the timescale, the less capital required to achieve a desired probability of sufficiency Comments on Q1(iv): Most candidates were able to identify that the market influences (e.g. competitors, rating agencies, position in insurance cycle) would have a significant impact on the probability of sufficiency to choose. Better candidates identified risk appetite, the increased cost of holding more extreme scenarios, reserve discounting, existing available capital and insurer reputation as important considerations. A large number of candidates suggested that a higher percentile should be used for classes with greater variability demonstrating the lack of understanding of percentiles. 2 (i) Risks of not building rating model The premium charged by the underwriter may be insufficient due to features that would be identified by the rating model but not by the underwriter. Lack of rating factors in existing rating may lead to risk of anti-selection, in particular by other insurers who are collecting and analysing up-to-date data and have better rating structures to the extent that the underwriter s own knowledge is insufficient for ideal rating. Significant risk of concentration of knowledge in one underwriter. If the underwriter was suddenly to leave the company, risk of not finding replacement underwriter of similar expertise. The junior assistant is unlikely to have the necessary underwriting experience in the short term. Very difficult for the underwriter to accurately adjust prices for changing assumptions without a rating model, such as: expenses commission rates investment conditions capital required e.g. as nature/size of company changes changes in regulatory environment target profitability Page 6

149 Subject SA3 (General Insurance Specialist Applications) April 2009 Examiners Report change in claims environment latent claims inflation (claims, expenses) changes in exposure cost and structure of reinsurance Subjective allowance for cross subsidies. Difficulty in measuring profitability performance of this class of business. Accurate rate change information unlikely to be available. Lack of explicit rate monitoring processes and data capture may not meet regulatory requirements. Potentially higher solvency requirements from regulators due to Solvency II Small company => claims volatility and rating accuracy are significant risks Difficulty in setting appropriate reserves for account as difficult to gauge rate adequacy against accurate technical rate. Risk of writing loss making business if underwriter continues to use US rating model as US claims experience may not be relevant to UK and other European countries Different coverage/terms and conditions in the US compared to UK and other European countries and different legal/regulatory environment in the US compared to UK and other European countries. Pricing assumptions may not have been updated for 5 years. In particular claims inflation may have been considerably higher during the period. Greater danger of being influenced by market cycle as no relevant technical rate available to guide the underwriter. The underwriter only occasionally uses the model, possibility selecting occasions when US relativities are too low and possibly inconsistent with the junior underwriter s judgement. Lack of clear audit trail for internal peer review process. Rating models may not have been properly checked in the first place. Risk of losing business to peers with accessible online systems. Reinsurers may not trust rate adequacy resulting in higher reinsurance costs. Comments on Q2(i): Too many candidates focused on what would make up a rating model rather than considering the wider commercial and business implications of having an effective rating process. (ii) Advantages to underwriter More time to concentrate on underwriting more complex cases. Simplified rating approach on standard risks. Ability to quote quicker to assist expansion. Potential to write higher volumes through efficiency savings or make more careful selections for risks taken on. Page 7

150 Subject SA3 (General Insurance Specialist Applications) April 2009 Examiners Report Potential to identify underpriced renewals to correct rating or decline at renewal, or overpriced renewals to compete more aggressively at renewal. Easier/quicker to demonstrate profitable performance of account. Capture of granular exposure information would make it easier to adjust profit assumptions e.g. in the light of a legal change. Ultimate loss ratios described by underwriter are not necessarily an accurate indicator, only backward looking and more easily attributable to good fortune Better understanding of account from rating exercise and perhaps formal collection of additional rating information within rating tool and on IT systems Less time explaining account to management. Junior assistant requires lower training burden as knowledge within tool Fewer risks with resourcing. Rating model could provide a more robust benchmark price compared toposition in market cycle including year on year price changes relative to benchmark. Consistency in approach to pricing risks (improves reputation with brokers). May be able to negotiate better reinsurance terms using the better data. Internal peer review easier. Meets regulatory underwriting standards better. Highlights areas where the underwriter s judgement is out of line with market prices which may improve underwriting quality. Can establish web / auto quoting for small homogeneous risks. Comments on Q2(ii): In parts (i) and (ii), better candidates appreciated that the advantages to the underwriter of building a model were not simply a reverse of the risks to the company of not building a model. Better candidates recognised the level of subjectivity and lack of a clear audit trail of the underwriter's decision making process as well as the potential risks involved with the use of an inappropriate and out of date US rating model. (iii) Information requested Underwriting: Book rates and existing method of pricing adopted. Trades/occupations covered/declined. Existing rating factors considered/available. Level of subjectivity needed. Scale of size discounts. Approach to pricing different limits of indemnity if applicable, e.g. increased limit factor (ILF) curves used. Distribution channel of business written. Different policy wordings/terms and conditions used. Exclusions and excesses for other European business. Information provided by client when risk quoted, in particular the claims history provided to assess what (if any) experience rating possible. Frequency of claims. Page 8

151 Subject SA3 (General Insurance Specialist Applications) April 2009 Examiners Report Exposure information for account. Any limits to individual policyholder exposure (by manual/clerical wageroll). Typical limits of indemnity / size of risks in portfolio. Countries risks written in / currencies risks written in. Views on market cycle (current prices soft/hard?) Any current competitor rates available. Time available per risk for pricing/time constraints. Conversion rate and viability of quoting before/afterwards. Expected future claims inflation to apply (will want to build this into the model and will be necessary if integrating rate monitoring into the process) Existing risk data that could be used to (at least partially) populate a rating database for renewal risks to save time. Potential latent issues not yet showing in claims experience. Reinsurance: Reinsurance structure. Current costs of reinsurance, net of recoveries. Expected changes in the above. Any feedback from reinsurers on current portfolio against market average. Claims Fgu claims history for line of business. Ideally 10 years of data. Transaction level detail if possible. Split between payment type (legal costs, compensation, loss of earnings, etc.) and/or paid & incurred triangles. Split by territory, industry, peril, rating cell. Gross/net of reinsurance. To understand development of claims for experience rating and payment pattern to estimate investment income. Details of historical changes in processes, controls, systems, external factors (e.g. legislation). Nil claims. Catastrophes/unusually light or heavy experience. Potential latent issues not yet showing in claims experience. Any benchmark/market data that may assist in building model. Cost of handling claims. Information on large claims in market, not just own account. Views on claims inflation split between legal fees, compensation, cost of care, loss of income. Finance: Expenses including relevant allowance for inflation including any breakdown of expenses available (direct/indirect). Commission levels (e.g. any fixed fees, differential new business/renewal commission rates). Interest rate assumed / investment income information. Capital requirements and return on capital required for this business. Taxation (corporation tax, IPT). Future agreed budgets/plans/forecasts for employers liability account. Page 9

152 Subject SA3 (General Insurance Specialist Applications) April 2009 Examiners Report Comments on Q2(iii): This was answered well by most candidates. Better candidates identified that most information would be required from the Underwriting and Claims areas and therefore gave greater focus to these areas in their answers. However, there was a seemingly universal lack of awareness of the statutory nature of EL cover in the UK meaning that deductibles are not applicable and limits are generally the same. (iv) Significant problems Biggest problem is lack of data especially as small company. Particularly in respect of disease claims. Meaning little information in any rating cell and employers liability claims frequency low so huge reliance on underwriter opinion. May be few rating factors following rating model review that are hard to define (underwriter s view). Potential errors in the data. Difficulty in building in different rules for each European country. Future court awards unpredictable. Costs of building rating models may be prohibitive (and lack of expertise to build). Added uncertainty around projected burning costs (appropriate allowances for IBNR/IBNER). Potential problem with underwriter buy in. Particular problems if pricing higher limits of indemnity as incidence of large claims even lower. Latent claims are difficult to allow for objectively. Potential IT problems if aiming to embed into existing systems. Comments on Q2(iv): This was reasonably well answered, although few candidates identified the lack of disease claims history and issues around different rules for European business (v) Advantages: Additional source of revenue with very little resource/cost required to set up arrangement internally. Greater expertise of MGA could provide potential to underwrite other types of business not currently written by insurance company.. Relevant examples. Based in the UK so no currency risks. Marketing undertaken by MGA rather than coinsurers. Diversify portfolio exposure into other types of business/countries thus reducing accumulation risk. Could provide expertise in handling claims for non-standard risks or claims Provides policy and claims administration through its own IT systems so little ongoing cost for insurer. Lead insurer likely to be responsible for MGA audits so lower ongoing administration costs. Page 10

153 Subject SA3 (General Insurance Specialist Applications) April 2009 Examiners Report If MGA fails, the insurance company is only liable for its coinsurance share of claims (i.e. lower risk than taking on whole risk and reinsuring). If arrangement successful, could lead to additional capacity offered for other classes of business (e.g. public and product liability) or cross selling. Disadvantages: Less control over underwriting decisions and risk that policy wording may be undesirable. Could lead to undesirable risks being underwritten. Potential concentration of risk and/or aggregation of risk with own portfolio. Certain risks may fall outside existing reinsurance limits or may expose insurance company to risks not authorised to write by regulator. Capacity limits would have to be imposed due to limited capital of insurance company which may in itself restrict the type of business written MGA may be competing for same target market as insurance company which may result in company effectively competing against itself for same business or could cause broker relationship issues if through same distribution channel. MGA likely to request higher commission rates or fees compared to company selling through brokers. May not provide same return on capital compared to existing portfolio. Potential loss of or reduced level of management information if MGA s IT systems are substandard. Less experienced MGA claims handling staff may result in higher ultimate claims costs. Potential lack of experience in handling particularly complex claim cases involving serious injuries. Claims handling fees may be higher than equivalent cost of insurance company s own claims handlers. Different claims handling philosophy to insurance company may imply difficulty in establishing accurate claims reserves. Especially if MGA is relatively new with little historical claims development. Likely to be contractually tied into arrangement for an agreed period so difficult to walk away immediately from arrangement if results are poor. Increased delay between policyholder paying premium and receipt of premiums from MGA due to credit agreements between broker, MGA and insurance company meaning potential loss of investment income. Revenue stream and service elements dependent on MGA staying in business. Potential credit risk with binding arrangements. Time delay on claims bordereaux will mean that internal development patterns will not work well for the binding risks; may have to project separately. Harder to exit the market rapidly if needed. Reinsurer may not like the third party involvement. May cause resentment with internal underwriter over loss of control or may impose additional supervisory burden on in house underwriter to keep track of the business. Moral hazard dependent upon MGA share of risk (e.g. underwriting risk) Page 11

154 Subject SA3 (General Insurance Specialist Applications) April 2009 Examiners Report May be difficult to assign ownership; if the in house underwriter is responsible for the business then he may object to the risk to his bonus. Comments on Q2(iv): This was poorly answered by many candidates. A significant number of candidates did not generate a broad range of advantages and disadvantages. Many candidates were unfamiliar with the concepts of binding arrangements and managing general agents which are very topical subjects. END OF EXAMINERS REPORT Page 12

155 Faculty of Actuaries Institute of Actuaries EXAMINATION 6 October 2009 (pm) Subject SA3 General Insurance Specialist Applications 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 both 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. SA3 S2009 Faculty of Actuaries Institute of Actuaries

156 1 Lloyd s managing agency A is considering taking over a smaller Lloyd s managing agency B whose single syndicate has recently had some extremely poor experience. This has left it without the capital strength necessary to compete effectively and attract business, although it is currently still solvent. (i) Set out the key issues and risks that need to be considered in this takeover, indicating any specific aspects that could materially impact these risks. [22] One of the units in B s syndicate that is causing particular concern is the Special Situations Unit. Agency B uses this unit to group a variety of individual niche products that don t fall into the target markets of their main underwriting units, including a number of contingency risks. (ii) Outline the general advantages and disadvantages of such a business unit. [5] (iii) (a) Define contingency business. (b) Give two examples of the types of risk that could fall into this category (excluding prize indemnity insurance). [3] One major source of premium written to this unit is a portfolio of prize indemnity insurance risks. The portfolio is written under a binding arrangement with a third party coverholder that manages the underwriting and claims handling with the syndicate providing the capital backing.. The policies written cover fixed prize lotteries each with their own weekly draw and various levels of ticket sales, with tickets often sold through affiliate groupings or business connections. All the draws are on the same basis, with five unique numbers per 1 ticket chosen from 50 possible numbers (the order of the numbers is not important) and three fixed prize levels as follows: All five numbers: 100,000 Any four out of five: 1,000 Any three out of five: 100 The insurance covers the top two prizes at a premium of 25p per ticket, 20% of which is paid to the binding authority underwriter to cover commission and expenses. (iv) (v) Deduce the planned loss ratio that Agency A would estimate for this business. [5] Discuss the likely advantages and disadvantages of continuing to write this type of risk. [8] Analysing the business in more detail has shown that one of the major sources of the recent poor experience has been its professional indemnity business. This originally focused on high value international clients, and has recently expanded rapidly to develop a strong regional presence underwriting small to medium sized businesses, particularly in the solicitors indemnity market. SA3 S2009 2

157 As the board of agency A has little experience of this business it would benefit from an introduction to the type of experience that might be expected and the way that this business is written. (vi) List the key features of professional indemnity insurance. [6] The board would also like to understand the risks relating to this book of business, including any key historic and ongoing features of this particular account and any current market conditions that might affect these risks. (vii) Outline the key exposures to Agency A from this book of business and the main investigations into this account that they should consider in order to understand the risks better. [14] The board of Agency A has decided to go ahead with the takeover, but is unsure of the ways in which it could be done and the key regulatory requirements that must be observed in setting up a combined Managing Agency. (viii) Outline the options available for a takeover, including the regulatory issues that should be considered. [6] [Total 69] SA3 S PLEASE TURN OVER

158 2 An investment banker is considering two UK general insurance companies as potential acquisition targets for a client. The client is a multinational group of insurance companies. The following information on the target companies has been provided. The project is at an early stage so that at present only limited information is available on the targets. Amounts in millions Company A Company B MCR ECR ICA ICG Note: Both target companies have the same premium income. (i) State the meaning of each of the abbreviations MCR, ECR, ICA and ICG and give a brief description. Details of how these amounts are calculated are not required. [5] The bank is meeting with its client tomorrow, and capital requirements will be discussed at the meeting. The banker would like to understand the likely reasons for differences in the numbers, and in particular the following features of the data: Company B has a higher ECR, although both companies have the same MCR. Company A has a higher ICA than company B. Company B has an ICG greater than its ICA, but the ICA and ICG are the same for company A. (ii) Write notes describing the possible key reasons for the differences noted in the list above. [18] The banker believes that the client may want to consider alternative levels of capitalisation, other than the capital requirements given in the table above, when considering which company to acquire. (iii) Discuss examples of capital requirements, other than those listed above, which should interest the client. [8] [Total 31] END OF PAPER SA3 S2009 4

159 Faculty of Actuaries Institute of Actuaries Subject SA3 General Insurance Specialist Applications September 2009 examinations EXAMINERS REPORT Introduction The attached subject report has been written by the Principal Examiner with the aim of helping candidates. The questions and comments are based around Core Reading as the interpretation of the syllabus to which the examiners are working. They have however given credit for any alternative approach or interpretation which they consider to be reasonable. R D Muckart Chairman of the Board of Examiners December 2009 Comments for individual question are given with the solutions below. Faculty of Actuaries Institute of Actuaries

160 Subject SA3 (General Insurance Specialist Applications) September 2009 Examiners Report 1 (i) Key issues to investigate Reserve adequacy company is currently solvent under their reserving methodology, but capital backing is obviously weak. If over-reserved there is a potential benefit to the company but given the company is in a weak capital position that is leaving it vulnerable to takeover it is unlikely to be materially over-reserved as they would most likely have moved to a best estimate basis to remain solvent enough to continue trading / attract a more favourable takeover settlement, leaving it far more likely that any risk is to the downside due to the company being under-reserved One aspect that materially affects this level of risk is the length of tail and level of uncertainty of the business lines being written with shorter tail classes such as property posing significantly less reserving risk than longer tailed classes. along with the length of time the syndicate has been in operation if there are any longer tailed lines as that increases the number of years on which reserves could potentially deteriorate including any inherited lines and discontinued business units Reasons for the poor loss experience e.g. was it due to a series of unfortunate major claim events e.g. catastrophes, higher than anticipated latent claim amounts in which case one would need to consider whether or not the business is adequately diversified / protected against such volatility and whether any lack of diversification is simply due to the small size of the syndicate and once integrated into your larger syndicate such volatility wouldn t be so material and is the likelihood of any further such volatility within your agency s risk tolerance and if due to major claim events were these market claim events that materially affected their peers or were they isolated events of bad underwriting judgement / luck for this syndicate or was it due to poor underwriting controls allowing the unit to write excessively large lines on individual risks or a failure to properly manage aggregate limits in particular areas or was it simply due to inadequate rating levels or was it poor claims controls or an increase in fraud and if so can these be addressed with improved internal controls / rating models and are the market conditions going forward likely to offer a more favourable rating environment Page 2

161 Subject SA3 (General Insurance Specialist Applications) September 2009 Examiners Report Is any poor experience confined to only some of the underwriting units and if so is there any scope for discontinuing these units and going forward with the profitable underwriting teams only although the impact on morale of this move must be considered Synergies with the existing business e.g. with the IT systems (or other appropriate example) most importantly is the business written likely to complement the business your agency already writes and add to diversity and add genuine growth opportunities and/or to only retain those underwriting teams whose market segments are not already covered Do the underwriting teams that your business might seek to retain have valuable expertise / intellectual capital and how much of their client / premium base is likely to be loyal and easily transferable to your new business and the impact on broker relationships Are there potential expense savings / economies of scale from integrating the two businesses with particular consideration as to whether your company already has the necessary expertise to support any new business lines / claim types etc. Difficulties in letting go / retaining their current management team Capital savings from integrating the two businesses in particular the level of diversification credit from adding a complementary portfolio and the reduced volatility from simply having a larger overall business Price at which the business could be obtained Opportunity cost of alternatives Any other potential buyers and the impact this will have on the price e.g. risk of paying too much Costs associated with the take-over e.g. administration, advisory and the receptiveness of their staff base to the takeover opportunity along with moral issues for your managing agency in such a move Free capital for such a takeover opportunity or the scope to raise additional debt to finance it / price of such debt impact on A s credit rating Page 3

162 Subject SA3 (General Insurance Specialist Applications) September 2009 Examiners Report Attitude of other stakeholders to the takeover including: your shareholders / the general market, names, your debt providers, your reinsurers, Lloyds / FSA, rating agencies Security / value of assets held e.g. are they readily tradable liquid assets whose value is clear. and are they adequately matched to the liabilities both by currency and term Security of any outwards reinsurance contracts on the inherited business adequacy of bad debt reserves which could be a material issue if the poor loss experience was due to a market wide issue that would impact reinsurers or if the poor experience relates to older years for which the reinsurers may be less likely to still be trading Debt held by the syndicate and whether there is any opportunity to refinance and improve profitability there especially if your managing agency has a superior credit rating Any tax benefits to be gained Any other relevant suggestions There was a significant variation in the quality of responses to this question. Candidates generally fared better on the more generic issues to consider in a takeover (synergies, diversification, reactions of stakeholders etc.) although not in general covering sufficient issues. However, a disappointing number gave little or no consideration to the most pressing issues in the situation described in the question: what caused the poor experience, how much potential is there for the existing experience to deteriorate further and how much potential would there be to turn the experience around and have a profitable business going forward. Candidates should clearly recognise the far greater risks in taking over long-tailed business with significant latent potential suffering from significant under-reserving issues than in taking over short-tailed business suffering as a result of a recent catastrophe event with inadequate reinsurance or diversification. Few candidates gave more than a cursory consideration to these most critical aspects, suggesting either poor exam technique or a lack of awareness of the relative significance of different types of risk. A surprising number of candidates also failed to address the single most important point, i.e. the price at which Agency B could be purchased. (ii) Advantages / disadvantages (+/ ) + Niche business can be significantly more profitable than higher volume business lines + due to the lack of competition in the market Page 4

163 Subject SA3 (General Insurance Specialist Applications) September 2009 Examiners Report + Having a separate specialist team to pass unusual but profitable risks to allows the main underwriting teams to focus on their areas of expertise + without turning down good business + Capital requirements are often low when written as part of a larger business as niche business is frequently uncorrelated with other lines + / Requires very specialist underwriting although this could be an advantage if the specialist skill is available as it reduces the scope for new entrants into the market + Reinsurance may be easier to obtain given specialist knowledge of the team to find the right reinsurer and package - alternatively reinsurance may be harder to obtain for niche products despite internal specialist skill Often difficult to analyse as all cases are so individual that few data are available so true underlying profitability can be difficult to ascertain along with difficulties in business monitoring including rating and reserving projections Contingency business in particular can be notoriously difficult to analyse and the loss record in the market is often poor as a result of this Difficult to set standard underwriting controls as each case is so different meaning that the unit may well require a high level of management supervision / expense compared to the premium volumes written This question was generally interpreted as to why you may want a Special Situations Unit separate from the main business (as opposed to why have one at all). Both interpretations are valid and many of the relevant points are valid under either interpretation. Most candidates recognised the advantage of being able to give unusual risks the focus they need although many failed to address the key reason for writing a niche product being the potential for higher profits because of a lack of competition and many failed to point out the difficulties in pricing and reserving because of heterogeneity and paucity of data. (iii) Contingency insurance provides financial compensation for specific insured events that cause the insured delay, expense or an inability to continue current professional activities Examples include: Event cancellation due to weather / venue damage etc. Page 5

164 Subject SA3 (General Insurance Specialist Applications) September 2009 Examiners Report Film risks including death of cast members, damage to props etc. Non appearance e.g. musician refusing to turn up / falling ill etc. Legal delays costs incurred if a case overruns due to death or damage of a participant Product recall sometimes Specialist life / disablement cover J-Lo s bottom, that wine taster s nose etc. Although this risk type is not considered in the core reading and has not featured in past exam questions, at SA3 level candidates are expected to display general market knowledge including awareness of less mainstream product lines such as contingency insurance which is on offer from a number of different product providers and features regularly in the media when coverage is offered for highly specific and unusual risks, often with a celebrity focus. Because of the lack of a specific, core reading definition some level of credit was given for any reasonable attempt at a definition, although many candidates guesses were either contradictory, incomprehensible or inappropriate as a form of insurance. (iv) Expected claims cost from the top prize = chances of getting all 5 correct out of 50: = 1 in 2,118,760 expected cost of 4.72p per ticket to cover this prize Expected claims cost from the second prize: 5 possible ways of picking 4 of the 5 correct numbers Each of those can be combined with any of the 45 remaining possible numbers Therefore 5 combination 45 = 225 possible ways of picking 4 out of 5 from any 2,118,760 possible overall combinations 225 / = 10.62p per ticket Net premium after binding authority underwriter s commission & expenses = 20p per ticket You work for a Lloyds syndicate so all accounting would be done on a net of commission and external expenses basis (award marks for alternative appropriate assumption stated) Expected loss ratio = ( )/20 = 76.7% Page 6

165 Subject SA3 (General Insurance Specialist Applications) September 2009 Examiners Report Candidates at this level should possess the appropriate understanding of probability to answer this question, and although many candidates could produce reasonable answers for the probability of all five numbers remarkably few were capable of calculating the probability of four out of five numbers. Some papers also included comments that the calculation would in some way depend on the number of tickets sold. Many candidates failed to carry out even a basic sense check on their numbers. A number of candidates failed to pass comment even after producing loss ratios of less than 1%, and while the marking schedules do not explicitly penalise such an omission it does form part of the subjective assessments made of candidates close to the borderline. (v) Advantages / disadvantages + Some profit to be made especially since internal expenses are likely to be low as underwriting is done externally also potential for increased profits if some winning tickets are lost / not claimed + Purely mathematical calculation, no subjectivity at all so profitability can be assessed with confidence which also makes it easy to set clear parameters for the binding authority to write to a target profitability for any other business + Easy to obtain reinsurance given that the product is easy to price + Extremely short tailed business (claim event known at the end of the draw) leading to reduced uncertainty + Should be entirely random therefore utterly uncorrelated with everything else meaning capital requirements for this business would be very low if it is a small part of the overall premium base, because of diversification credit and also meaning all separate risks and individual draws are utterly independent so there is no risk of aggregation + Premium volumes should be reasonably stable as it is an aggregation of thousands of individual ticket purchases + As the question specifies this comprises a major source of premium then at 20p premium per ticket it is likely that volumes are high suggesting any volatility would be pretty low, at least over a 1 year timescale + Rating levels may be fairly stable as it is a fixed priced product Risk of moral hazard depending on the independence of the draw would want to check how the draw is handled and/or insist on an independent witness of your own choosing to supervise each draw although this may add a prohibitive level of expense Page 7

166 Subject SA3 (General Insurance Specialist Applications) September 2009 Examiners Report Would also request a database of all tickets to be sent through before each draw Risk of fraud e.g. printing of tickets Loss ratio is comparatively high, may not meet internal requirements although given the low capital needed on a ROC basis this is unlikely Potentially high annual volatility particularly if ticket volumes lower than expected or if popular numbers are selected e.g. birthday dates (award point for mentioning accumulation of risk due to numbers selected) Potentially high weekly / monthly volatility even with higher sales volumes e.g. even 5m of annual premium suggests 25m tickets sold a year or 500k a week, so the top prize particularly can be volatile in the short term with only about 1 claim expected every 4 weeks and possible cashflow issues resulting from that although the managing agency is large enough that it is unlikely to be an issue unless there is material risk in different currencies to the rest of the business Very few candidates understood the issue being tested here of the implications of a completely random (barring fraud) and mathematically calculable product and simply offered a generic answer on binding arrangements. Many candidates commented that there was a risk of ceding control of underwriting under binder arrangements, without considering that underwriting simply is not a factor for a policy where the risk can be calculated exactly. The majority of candidates failed to recognise that a purely random product like this would by its very nature offer complete diversification with every other line of business, making at best generic comments that it might offer diversification depending on other lines of business written. A number of candidates also wrongly commented that this would not constitute an appropriate product as the insured had no financial interest in the outcome, in spite of the insurance contract clearly being with the lottery provider who is responsible for paying the claims and who clearly has a significant financial interest. Also points about moral hazard and what action could be taken were generally not made. (vi) List some key features of professional indemnity insurance (key points) Covers professionals against the consequences of flawed professional advice Specialty business generally written through brokers Sometimes compulsory cover for certain professions There are often cover restrictions and exclusions Key exposure measure is usually fees Page 8

167 Subject SA3 (General Insurance Specialist Applications) September 2009 Examiners Report Generally low frequency Claims can be high when they do occur and subject to court award inflation and earnings Accumulation risk following on from precedent cases Development is often slow, medium to long term business Affected by changes in legislation/regulation Any other reasonable comments e.g. changes in legislation affecting advice or actions retrospectively, latent claims in medical malpractice, moral hazard Additional points Solicitors business tends to renew on October Type of cover E&O Type of cover breach of duty Type of cover Civil Liability Example of a profession 2 nd example of a profession Sometimes rated on turnover Sometimes rated on number of partners Generally rated in more detail according to the split of fees by different types of activity Example of type of activity (e.g. conveyancing) Sometimes rated on experience basis for larger clients Development longer for some professions where the consequences of poor advice take longer to be realised (e.g. architects) Legal costs are usually covered Written to defined policy limits no unlimited liability Can be written as direct or reinsurance business e.g. reinsurance of a professional body Generally claims made (although can be losses occurring) Claims made will generally have retroactive date Comments on Q1(vi): Generally adequate answers on a largely bookwork question, although a majority of candidates suggested turnover or even wage-roll as the most common exposure measure with few mentioning fees. (vii) Potential concerns about professional indemnity business: Long-tail class so claims may take a while to emerge Page 9

168 Subject SA3 (General Insurance Specialist Applications) September 2009 Examiners Report Even those claims that do emerge can cover fairly unique situations that are often tested in court requiring highly subjective valuations based on good understanding of the risks and situations in question which makes the quality of the claims assessors used by the company critical in understanding the level of risk in the existing business Given the high value international clients there could be large claims and precedent cases and deep pockets syndrome and more general reserving methodology and development profiles for the business Particular attention to any changes in claim assessment methods / staff that might change the development profiles of the business Investigate reinsurance programme Given the slow development, rate changes are of critical importance for this business for early years of development as emerging experience will be insufficient / lack of data on solicitors New business strain as it's a growing book rapid expansion may be a result of under-pricing leading to solvency issues Coverage changes can also have significant impact on rate movements for this type of business e.g. costs in addition coverage Investigate potentialrecent significant market events and the impact (if any) on this book Investigate rate monitoring quality and methodology and portfolio analysis including allowances for any coverage changes Coverage offered can have a significant impact on the development profile of the business claims made versus losses occurring in particular Investigate the type of coverage offered and any trends or changes in coverage historically given change in mix of business Potential accumulation risk given strong regional presence Investigate level of expenses in running the business Currently in a very soft market for UK PI business particularly for solicitors business with a number of insurers reducing or withdrawing their product range with low profits or even losses expected to emerge from recent years across the market as a result of the low rates Business is also highly influenced by macroeconomic events Page 10

169 Subject SA3 (General Insurance Specialist Applications) September 2009 Examiners Report which are currently extremely unfavourable and likely to lead to a significant influx of claims such as valuation claims for surveyors or claims on conveyancers following the property market collapse or mis-selling claims for IFA s following losses on the stock market / savings etc. or from mortgage brokers for inappropriate sale of mortgage products / checking of documentation etc. This risk is increased given that there are more SME that will be more impacted by a recession Critical to understand the make up of the account and any overexposures to certain areas, country or currency e.g. is the solicitors book heavily weighted towards high risk areas such as conveyancing It was mainly generic bookwork answers that were produced for this question, including that it is highly influenced by macroeconomic events with very few candidates passing any comment whatsoever on what these recent macroeconomic events have been. With the first major recession since most candidates started their professional lives having dominated media coverage for more than two years we would have hoped that candidates had spent many months considering recessionary issues in their daily working lives and indeed that candidates would be expecting such a topical question. Many candidates failed to address the specifics in the question and simply gave a generalised list of potential risks for a book of business. The word outline in the question is being used to suggest a brief summary but many candidates gave very lengthy answers as to how they would perform a reserving analysis, often writing several pages, which only earned a couple of marks on the schedule. (viii) Methods of transferring the business: Insured is another Lloyd s syndicate so assets and liabilities can be transferred as needed through a reinsurance to close premium to one of the syndicates your agency manages Although the timing of this may not be ideal as that would require waiting until the years of account are to be closed A Novation e.g. part VII transfer or LPT would allow the assets & liabilities to be transferred in entirety If the managing agency is a listed company their shares can be purchased on the open market or via a takeover arrangement which would give instant access to the employees / intellectual capital / premium base etc. of the company Page 11

170 Subject SA3 (General Insurance Specialist Applications) September 2009 Examiners Report and allow the practical process of merging the companies to begin / the underwriters to continue writing to your agency s current syndicates Key stakeholders would need to be involved, namely Lloyd s / FSA, both of which would have minimum capital requirements for the merged entity which would need to be met requiring a new capital assessment to be put forward for the combined business to demonstrate adequate capital backing for the takeover The reserves of the newly combined entity will need to be reviewed and signed off Mentions of GN 12 / 20 / 33 & 50 as needed: professional guidance with relevant examples. This was not generally well answered, with many candidates demonstrating little knowledge of potential routes to purchase and giving little consideration to capital considerations that would form the cornerstone of regulatory interest in a takeover, often considering competition rules or treating customers fairly while not even mentioning capital. Very few mentioned professional guidance. A number of candidates discussed whether the syndicate should be run separately or incorporated into Syndicate A. 2 (i) Definitions of MCR, ECR, ICA, ICG MCR Minimum capital requirement. MCR is the greater of GICR (general insurance capital requirement) and the minimum guarantee fund (MGF/BCRR) set by the EU. Formula based calculation Essentially comprises capital charges as a percentage of claims or premiums. The capital charges only reflect the relative riskiness of different categories of claims and premiums to a very limited degree. Calculated is retrospective ECR Enhanced capital requirement. A more risk sensitive measure than the current EU directive minimum. Comprises capital charges as a percentage of claims, premiums and asset values. The capital charges reflect the relative riskiness of different categories of assets, claims and premiums. Currently a soft test of solvency not a hard test ICA Individual capital assessment. This capital assessment was introduced by the FSA. Page 12

171 Subject SA3 (General Insurance Specialist Applications) September 2009 Examiners Report Insurers are required to make their own regular assessments of the amount and quality of capital that is adequate for the size and nature of their businesses. Expressed as a percentage of ECR Aimed to be held at the 99.5th percentile level ICG Individual capital guidance The FSA s view of the level of capital that should be maintained. Based on the FSA s review of the firm s assessment of its capital needs and its risks. Most candidates scored highly on this very bookwork question. (ii) Differences Between MCR, ECR, ICA, ICG Reasons why ECR differs but MCR does not The ECR considers the assets held, as well as premiums written and reserves held Company B may hold riskier assets than company A/hold assets subject to a higher capital charge. Company B may hold more assets than company A The ECR charge factors for premiums written and reserves vary between classes. The MCR factors for premiums written and reserves do not vary by class with very few exceptions although there is some variation in MCR factors according to size of premiums and reserves. Company B may write more premium than company A in classes with higher charge factors. Company B may hold more reserves than company A in classes with higher charge factors. As the premium income is the same the MCRs will be equal if a premium basis was used, but the ECRs will still differ due to some of factors used in the calculation for example B may use a stronger reserving basis than A (or other relevant example) A might have suffered particularly bad claims experience recently, which has increased the MCR (as it's a retrospective calculation) to the same level as B's and has had no impact on A's ECR level. If A has suddenly contracted GWP then its ECR would reduce but MCR would be subject to the minimum brought forward GICR from last year (less reduction in o/s claims), which would keep it high. (or equivalent example) Page 13

172 Subject SA3 (General Insurance Specialist Applications) September 2009 Examiners Report Reasons why Company A has a higher ICA than Company B The insurance risk for company A may be higher than for company B. e.g. compared to Company B, Company A might: Write more volatile classes of business, e.g. more liability business, or more reinsurance Conversely, B may write more of classes where the ECR/MCR factors are high but the internally modelled risk is lower Write the same lines of business but select more volatile risks, e.g. there may be more geographic concentration risk in Company A s portfolio Company A may be more exposed to natural catastrophe losses Have a different reinsurance strategy Have a different reserving policy There may be differences in the credit risk accepted Company A might purchase more reinsurance Reinsurers of Company B may have better credit ratings Company B has lower outstanding balances with other debtors such as brokers, because of different distribution strategy (or other example) There may be differences in the market risk accepted Company A may have more foreign currency exposure (or other relevant example) Company B may have better quality assets (or other relevant example) There may be differences in liquidity risk accepted Company B may hold higher cash balances (or other relevant example) There may be differences in the operational risk or group risks accepted Company A may be reliant on legacy computer systems (or other relevant example) Company A may be more exposed to key policyholders or brokers (or other relevant example) The companies may be making different allowances for diversification in their ICA s Company B may write a range of uncorrelated classes of business, whereas company A might only write a single class (or other relevant example) The companies may be making different allowance for expected profitability in their ICA s Page 14

173 Subject SA3 (General Insurance Specialist Applications) September 2009 Examiners Report This may be because the classes of business written are at different points in the insurance cycle. The difference in ICA s may in part be due to differences in the judgements made by each company, rather than the inherent riskiness of the businesses. Considerable judgement is required as part of an ICA assessment. Some of the most critical areas require the most judgement, e.g. correlation assumptions. Alternatively, the difference may arise due to capability/quality or type of modelling techniques used, rather than judgement. The companies may be using a different time horizon in their ICA calculations, although in theory the different time horizons permitted should be equivalent. Reasons why Company B was given an ICG greater than its ICA For company B, the FSA took a different view of the capital required than was produced by the company. The FSA may have thought that some of the assumptions made by company B were too optimistic. The FSA may have thought that some risks in the business had not been identified or adequately assessed. Some candidates scored extremely well by considering the various moving parts of an ICA in detail. Knowledge of the more prescribed nature of the ECR and MCR was more patchy, although even this section was still well answered. Perhaps the most common reason for scoring low marks on the question was the allocation of time between the three aspects, with many candidates giving almost equal weight to all three. Good candidates recognised that there is really only one reason why the ICG would be higher than the ICA, i.e. that the regulator thinks the ICA is too optimistic! Other common errors were simply regurgitating bookwork points about the various capital measures without addressing them to the question in hand. (iii) Alternative Capital Measures May wish to consider future changes in statutory capital requirements. e.g. Solvency II Company will be concerned about return on future capital requirements, not just present requirement. However, there will be uncertainty regarding what the future requirements may be. Capital requirements indicated by an internal model (other than the one used for ICA). Page 15

174 Subject SA3 (General Insurance Specialist Applications) September 2009 Examiners Report The company may use different risk tolerances from FSA regulatory capital (which is at the 99.5th percentile). The company is likely to want to hold more capital than the ICG, as this is a fairly low level of capitalisation. May wish to hold more capital to avoid regulatory intervention/interference. The internal model will allow for diversification of the target with existing business. One target company may have a much lower capital requirement than the other if it is uncorrelated with the purchaser s existing activities. Capital requirements in other jurisdictions Purchaser may be regulated outside UK Capital required by rating agencies. Insurer may need to retain certain rating to attract business. Different rating agencies may impose different capital requirements. Consider amount of capital needed to purchase the target Need to get return on purchase price, not just the capital held by the insurer. May be interested in capital requirements of target on some other basis e.g. allowing for purchaser s future business plans, such as increasing premium or changing reinsurance requirements. Level of capital held by its competitors so that it is not out of line with them This was poorly answered. Many candidates focused only on formal capital requirements with acronyms, talking at length about GICR or MCR etc., giving no thought to wider business objectives and the role that capital considerations might play. END OF EXAMINERS REPORT Page 16