ca1-pu-12

CA1: CMP Upgrade 2011/12

The Actuarial Education Company © IFE: 2012 Examinations

Subject CA1

CMP Upgrade 2011/12

CMP Upgrade This CMP Upgrade lists all significant changes to the Core Reading and the ActEd material since last year so that you can manually amend your 2011 study material to make it suitable for study for the 2012 exams. It includes replacement pages and additional pages where appropriate. Alternatively, you can buy a full replacement set of up-to-date Course Notes at a significantly reduced price if you have previously bought the full price Course Notes in this subject. Please see our 2012 Student Brochure for more details.

This CMP Upgrade contains: All changes to the Syllabus objectives and Core Reading. Changes to the ActEd Course Notes, Series X Assignments and Question and

Answer Bank that will make them suitable for study for the 2012 exams.


© IFE: 2012 Examinations The Actuarial Education Company

1 Changes to the Syllabus objectives and Core Reading

1.1 Syllabus objectives Syllabus objective (3.1.3) has been slightly amended to: (3.1.3) Discuss the difference between systematic and diversifiable risk.

1.2 Core Reading Throughout the Core Reading, the word “systemic” has been replaced with “systematic”. Chapter 1 Pages 7 8 Section 3.2 has been significantly re-written. We recommend that you remove pages 7 8 from your Course Notes and use replacement pages 7 8c provided below. Pages 15 16 A discussion of the Actuarial Quality Framework has been added to the bottom of page 15 and to the Chapter Summary. We recommend that you remove pages 15 18 from your Course Notes and use the replacement pages provided below. Chapter 3 Pages 9 10 A short paragraph on corporate governance has been added to the top of page 9 and another one at the bottom of page 9. We recommend that you remove pages 9 10 from your Course Notes and use replacement pages 9 10c provided below. Chapter 28 Page 5 The whole of Section 2.2, Active money has been deleted.



Chapter 29 Page 19 A fourth bullet has been added to the list at the top of the page: by comparison with any available market data. Chapter 31 Page 17 A sixth bullet has been added to the list at the top of the page: untested market. Chapter 32 Pages 12 16 The whole of Section 3 (ie from page 12 to page 16) has been deleted. Chapter 35 Page 12 A tenth bullet has been added to the list: to provide disclosure information for beneficiaries. Chapter 37 Pages 1 4 Section 1 has been significantly re-written. We recommend that you remove pages 1 4 from your Course Notes and use the replacement pages provided below.



Page 12 A ninth bullet has been added to the list: membership movements. Chapter 39 Pages 2 4 In Section 1.2 all instances of the word “systemic” have been replaced with “systematic” (except in the “Note” on page 3). Chapter 45 Pages 5 8 Various parts of Section 2.3 have been deleted. We recommend you remove pages 5 8 from your Course Notes and use the replacement pages provided below. Chapter 47 Page 9 The first paragraph of Core Reading now reads: The Solvency II regime is still under development and is unlikely to be required in the UK until the beginning of 2013 at the earliest. The last sentence of Core Reading on the page now reads: Thus it is likely that most companies will use the standard model, although there is likely to be significant variation: in the UK the majority is expected to use an internal model. Pages 11 12 Section 2.2 has been significantly amended. We recommend you remove pages 11 12 from your Course Notes and use replacement pages 11 12c provided below.



Chapter 49 Page 4 A sentence has been added to the end of the definition of “Average earnings scheme”: Such schemes are alternatively referred to as career average schemes. Pages 26 In the definition of “systemic risk” (now called “systemic” risk), the last paragraph has been deleted. Hence the definition now reads: Systematic risk The risk of the individual share relative to the overall market which cannot be eliminated by diversification.



2 Changes to the ActEd Course Notes Throughout the ActEd Course Notes, the word “systemic” has been replaced with “systematic”. Chapter 0 Page 17 The following sentence has been added to the bottom of the example a third of the way down the page: Such differences in perception are likely to be linked to different risk appetites. Page 20 The first sentence on page 20 now reads: The Subject CA1 exam consists of two three-hour papers, with 15 minutes of reading time at the start of each paper. Page 24 A sentence has been added to the end of the first paragraph (after the text in the box): “Discuss” questions often require you to look at advantages and disadvantages. Chapter 1 Page 1 In the second sentence of the second paragraph of Section 0, replace “technical standards” with “Technical Actuarial Standards”. Pages 7 8 As stated above, Section 3.2 has been significantly re-written. We recommend that you remove pages 7 8 from your Course Notes and use replacement pages 7 8c provided below.



Pages 17 18 The section entitled “Professional framework of the Actuarial Profession” has been rewritten, due to changes in the Core Reading and this has affected the Chapter Summary. We recommend that you remove pages 17 18 from your Course Notes and use the replacement pages provided below. Chapter 2 Page 24 A sentence has been added to the third paragraph of Solution 2.1 part (iv). The paragraph now reads: The trustees of the scheme act on behalf of the members and will be concerned with security of benefits and managing investments. This suggests a preference for high contributions, but balanced against wanting the sponsor to continue to offer the scheme. A sentence has been added to the fourth paragraph of Solution 2.1 part (iv). The paragraph now reads: The auditors of the scheme and the regulator(s) will be particularly keen that all regulations and guidance have been adhered to, eg any requirements to demonstrate a minimum level of funding. Page 25 The second bullet of Solution 2.4 now reads: Timing of investment, eg lump sum or regular investment Chapter 3 Page 25 The first bullet of Solution 3.3 now reads: through a traditional insurance policy such as a with-profits or unit-linked

savings contract, where the benefits paid on death / maturity are dependent on the performance of the underlying investment(s).



Chapter 5 Page 17 A new bullet has been added to the start of Solution 5.5: day-to-day living costs – current Chapter 6 Page 6 The first paragraph of Section 1.7 now reads: A hybrid scheme offers benefits that may be the better of a defined benefit or defined contribution type benefit or schemes offering both defined benefit and defined contribution sections. Page 22 The first paragraph of ActEd text, relating to an article on CCRC’s, has been deleted. Page 27 The third paragraph of the Chapter Summary now reads: Hybrid – offers benefits that may be the better of a defined benefit or defined contribution type benefit or a scheme offering defined benefit and defined contribution sections. Chapter 7 Page 21 A new paragraph of ActEd text has been added after the first Core Reading paragraph in Section 11.1: A claim is payable on this contract when the policyholder is deemed to have reached a specified level of disability, for example the policyholder may be unable to perform a specified number of activities of daily living (ADLs).



Chapter 8 Page 6 The first sentence of Section 1.5 now reads: The starting point for determining a general insurance premium is the risk premium, also known as the theoretical cost. Page 8 The second bullet now reads: real assets (index-linked bonds, equities and property) to meet inflation-linked

liabilities and expenses (however, the volatile nature of a general insurer’s business and its need for liquidity will limit its appetite for property and equity to some extent)

Chapter 12 Page 24 The first paragraph of the Further Reading section has been deleted. Chapter 14 Pages 5 6 The explanation on page 5 of Section 1.4 has been significantly updated. We recommend that you remove pages 5 6 from your Course Notes and use the replacement pages provided below. Page 25 A sentence has been added to the end of the last paragraph on this page: However, at times of high / uncertain inflation, conventional bonds tend to offer higher nominal yields to compensate for the risk of the real return being eroded.



Chapter 18 Page 7 Some more explanation has been added to Section 3 (ie a new second paragraph, and an additional explanation of the fifth paragraph). We recommend that you remove pages 7 8 from your Course Notes and use the replacement pages provided below. Page 9 A new sentence has been added at the end of page 9, so the final paragraph now reads: A particular feature of UTs (as opposed to ITCs) is that unit trust managers are obliged to buy back units from investors, hence offering guaranteed marketability. (However some UTs may impose a minimum time period for the return of funds, particularly if the underlying assets are themselves unmarketable, eg property unit trusts.) Chapter 19 Page 4 The examples on page 4 have been updated. We recommend that you remove pages 3 4 from your Course Notes and use replacement pages 3 4c provided below. Chapter 20 Page 13 The first example has been explained further. The example now reads: A balance of payments deficit is likely to lead to currency weakness. This is

because more of the domestic currency makes its way into overseas circulation. Hence the supply of the domestic currency in the foreign markets will increase and its price will decrease. In other words, the currency is likely to weaken and so may require an increase in interest rates. Bond yields will tend to rise.



Chapter 22 Page 13 The second bullet of Solution 22.1 has been expanded. It now reads: the relative marketability of the two bonds (in general, index-linked bonds are

less marketable than conventional bonds) Chapter 23 Page 6 The first sentence of the fifth paragraph now reads: The method used will be consistent if the liabilities are valued on a discounted cashflow basis using the same discount rate as that used to value the assets. Chapter 24 Page 23 The first sentence under the title “Risk premiums” has been corrected, to read: The corporate bond risk premium is needed to compensate the investor for: Page 25 A sentence has been added at the bottom of the page: However, such an approach may be viewed as subjective and is difficult to explain.

Chapter 25 Page 23 Another bullet has been added to Solution 25.15: the need to protect capital values



Chapter 26 Page 2 The third bullet has been corrected, to read: an endowment assurance taken out to repay an interest only mortgage Chapter 27 Page 15 The first paragraph of the final bullet has been corrected, to read: These consist of the benefit payments specified in money terms, plus expense outgo less the premium / contribution income that is fixed in money terms. Chapter 28 Page 5 The whole of Section 2.2, Active money has been deleted. Page 25 The final paragraph under the “Measuring active risk” section, relating to active money, has been deleted. Chapter 29 Page 39 The second sentence of Solution 29.5 now reads: (Sensitivity analysis and scenario testing can then be carried out to assess the potential variability of the results.) Chapter 32 Pages 12 16 The whole of Section 3 (ie from page 12 to page 16) has been deleted.



Pages 21 22 The last two pages of the Chapter Summary (ie pages 21 22) have been deleted, because these relate to deleted Core Reading. Pages 25 26 Solutions 32.9 to 32.12 have been deleted, because these relate to material the from Section 3 that was also deleted. Chapter 34 Page 25 A final sentence has been added to the bottom of Solution 34.3: In practise, it is rare for such contracts to offer a discontinuance benefit. Chapter 35 Page 34 A tenth bullet has been added to the reasons for calculating provisions: to provide disclosure information to beneficiaries Page 35 An eight bullet has been added to the list of purposes: Disclosure information for beneficiaries – the assumptions will reflect

legislation, but a realistic basis will typically be used, with a range of results also provided.

Page 39 The third bullet of Solution 35.1 now reads: incidence of sickness and likely duration of illness, split by age, sex and

different types of illness



The sixth bullet of Solution 35.1 now reads: future entry rates to the scheme and likely entry age / sex of employees (if the

contribution rate for the future is being set too). Chapter 37 Pages 1 4 The ActEd text has been re-written due to changes to the Core Reading. As stated above, we recommend that you remove pages 1 4 from your Course Notes and use the replacement pages provided below. You should also renumber subsequent questions. Pages 13 14 The first page of the Chapter Summary has been re-written, due to changes to the Core Reading. We recommend that you remove pages 13 14 from your Course Notes and use the replacement pages provided below. Page 15 An eighth bullet has been added to the last list on page 15: membership movements. Pages 17 18 A new Solution 37.1 has been added. We recommend that you remove pages 17 18 from your Course Notes and use the replacement pages provided below. You can now renumber subsequent solutions. Chapter 38 Page 41 Another bullet has been added to Solution 38.8: operating a no claims discount system



Another bullet has been added to Solution 38.10: offering loyalty bonuses to encourage policyholders to stay Chapter 44 Page 35 Another sentence has been inserted into Solution 44.7, after the first sentence: It also helps to diversify risk, because the insurer can write more business for the same amount of capital. Pages 38 The first bullet of Solution 44.14 now reads: ● It caps losses, hence it allows the cedant to take on risks that could produce very

large claims. Chapter 45 Pages 5 8 As stated above, various parts of Section 2.3 have been deleted. We recommend you remove pages 5 8 from your Course Notes and use the replacement pages provided below. Pages 15 16 Two paragraphs on page 16 have been deleted, because they relate to delete Core Reading. We recommend you remove pages 15 16 from your Course Notes and use the replacement pages provided below. Chapter 47 Pages 11 12 As stated above, the Core Reading in Section 2.2 has been significantly amended. As a consequence, the ActEd text has also changed. We recommend you remove pages 11 12 from your Course Notes and use replacement pages 11 12c provided below.



Pages 19 20 Page 19 has been updated to reflect the new Core Reading. We recommend you remove pages 19 20 from your Course Notes and use the replacement pages provided. Chapter 48 Page 3 Question 48.3 has been reworded. It now reads: If the investments held in a defined benefit scheme achieve higher than expected returns, who benefits?



3 Changes to the Q&A Bank Part 1 Questions Question 1.12 part (i) is now worth 4 marks. Therefore in total this question is now worth 12 marks. Question 1.20 part (i) is now worth 7 marks. Therefore in total this question is now worth 9 marks. Question 1.21 is now worth 8 marks. The following rows have been added to the table on page 9:

Paper Exam sitting Question No. Chapter(s) Marks

1 September 2010 3 4 11 1 September 2010 4 4 12 2 September 2010 6 1, 4, 6 37 1 April 2011 3 4 12 2 April 2011 1 6 8 2 April 2011 7 1, 4 20

Part 1 Solutions The marking scheme for Question 1.12 part (i) is now: [½ each, maximum 4] Solution 1.18 has been re-written, following changes to the Core Reading. We recommend you remove pages 13 14 and use the replacement pages provided below. The marking allocation on pages 17 18 has been updated to more realistically reflect exam standards. We recommend you remove pages 17 18 and use the replacement pages provided below. (Note that Solution 1.20 part (i) is now worth a maximum of 7 marks, but the solution itself has not changed.) Part 2 Questions Question 2.12 part (i)(a) and (i)(b) are now worth 4 marks each. Therefore in total this question is now worth 20 marks.



The following rows have been added to the table on page 7:


1 September 2010 4 10 12 2 September 2010 1 10 8 2 September 2010 4 8, 10 14 1 April 2011 3(i) and (ii) 8 9 1 April 2011 6(i) 8 5

Part 2 Solutions The first paragraph of Solution 2.1 part (iii) now reads: The contract can be used to cover, or help to cover, the cost of care in old age when individuals are no longer able to look after themselves. [½] This might be home-based care or care in a nursing or residential home. [½] The marking allocations for Solution 2.12 parts (i)(a) and (i)(b) are now: [½ each, maximum 4] (Note that the solutions themselves have not changed.) The second paragraph of Solution 2.14 part (i) now reads: A without-profit contract provides this cover with greater certainty about the cost ... [½] ... on a unit-linked version, charges are often variable. This may discourage some prospective consumers. [½] Part 3 Questions Question 3.3 is now worth 7 marks. Question 3.5 is now worth 2 marks. In Question 3.14, part (i) is now worth 7 marks and part (iii) is now worth 3 marks, so the total number of marks available is now 13.





1 September 2010 6 11 31 2 September 2010 2 11 10 2 September 2010 5 14 19 1 April 2011 7 12 19

Part 3 Solutions The marking allocations for many questions have been updated to more realistically reflect exam standards. We recommend you use the 2012 version of the Q&A Bank to see the updated marking allocations. Note however that there have been very few significant changes to the contents of the solutions themselves. Significant changes are given below: In Solution 3.21 part (iii): A new sentence has been inserted under Security: In general, corporate bonds are less secure than government bonds. [½] Another new sentence has been inserted under Marketability: In general, corporate bonds are less marketable than government bonds. [½] Part 4 Questions Question 4.14 is now worth 8 marks. Question 4.17 is now worth 8 marks. Question 4.20 part (iii) is now worth 3 marks, so that in total this question is now worth 10 marks.





1 September 2010 5 18 15 2 September 2010 3 16 12 1 April 2011 5(i) and (iv) 17 12 2 April 2011 3 18 16

Part 4 Solutions The third bullet of Solution 4.3 is now worth ½. The third bullet of Solution 4.6 now reads: the large minimum size of property investment [½]

the last two points will result in a unitised fund having to hold relatively large amounts of cash, which may reduce the expected return on the fund. [½] In Solution 4.12 part (ii), the third bullet now reads: to enhance expected return, ie:

– exposure to gearing (more limited for OEICs or UTs) [½]

– narrowing of the discount to NAV (ITCs only) [½] The marking schedule for Solution 4.14 is now: [½ each, total 8] The second point and last two points of Solution 4.17 are now worth ½ each. The marking allocation for Solution 4.20 part (iii) has been updated to more realistically reflect exam standards. The second, third and fifth points for this part are now worth ½ each, so that part (iii) is now worth a maximum of three marks. Part 5 Questions Questions 5.2 and 5.3 are now worth 6 marks each. Question 5.5 is now worth 8 marks. Question 5.6 parts (i) and (ii) are now worth 2 and 12 marks respectively.



Question 5.8 is now worth 5 marks. Question 5.11 is now worth 3 marks. Question 5.15 is now worth 6 marks. Question 5.18 parts (ii) and (iii) are now worth 4 and 3 marks respectively. This question is now worth a total of 13 marks. Question 5.19 is now worth 6 marks. Question 5.22 part (i) is now worth 8 marks, so this question is now worth 11 marks in total. The following rows have been added to the table on page 7:


2 September 2010 3 20, 21 12 2 September 2010 5 23, 24 19 2 April 2011 6(i) 20 10

Part 5 Solutions The marking allocations for many questions have been updated to more realistically reflect exam standards. We recommend you use the 2012 version of the Q&A Bank to see the updated marking allocations. Note however that there have been no significant changes to the contents of the solutions themselves. Part 6 Questions Question 6.3 is now worth 1 mark. Question 6.5 is now worth 5 marks. Question 6.10 part (ii) is now worth 2 marks so this question is worth 4 in total. Question 6.11 part (i) is now worth 3 marks so this question is worth 7 in total.





1 September 2010 5 26 15 2 September 2010 5 27 19 2 April 2011 3 26 16

Part 6 Solutions The marking allocations for many questions have been updated to more realistically reflect exam standards. We recommend you use the 2012 version of the Q&A Bank to see the updated marking allocations. Note however that there has been only one significant change to the contents of the solutions themselves: A new sentence has been inserted after the sixth sentence of Solution 6.13: ... and in practice only a limited number of runs will be feasible. [½] Part 7 Questions Question 7.6 is now worth 6 marks. Question 7.13 is now worth 3 marks. Question 7.18 is now worth 5 marks. Question 7.25 is now worth 8 marks. Question 7.26 part (i) is now worth 5 marks so this question is worth 8 marks in total. Question 7.27 part (i) is now worth 4 marks so this question is worth 16 marks in total. Question 7.30 is now worth 10 marks.





1 September 2010 7 33 15 2 September 2010 1 33 8 2 September 2010 4 32 14 1 April 2011 1 33 8 1 April 2011 6(iii) 31 9 2 April 2011 2(i) 31 2 2 April 2011 6(ii) and (iii) 29 11 2 April 2011 7(i), (ii) (iv) 30, 32 15

Part 7 Solutions The marking allocations for many questions have been updated to more realistically reflect exam standards. We recommend you use the 2012 version of the Q&A Bank to see the updated marking allocations. Note however that there has been only one significant change to the contents of the solutions themselves: Solution 7.20 part (ii) now reads: (ii) Fixed expenses are those that, in the short to medium term, do not vary

according to the level of business being handled. [½]

Part 8 Questions Question 8.3 is now worth 3 marks. Question 8.4 is now worth 5 marks. Question 8.7 is now worth 8 marks. Question 8.8 is now worth 6 marks. Question 8.18 is now worth 6 marks. Question 8.20 part (i) is now worth 3 marks so this question is worth 13 marks in total.



Question 8.21 parts (i) and (ii)(b) are now worth 4 marks each so this question is worth 23 marks in total. The following rows have been added to the table on page 9:


1 September 2010 1 37 7 1 September 2010 2 38 9 2 September 2010 6 37 37 1 April 2011 4 35, 37 17 2 April 2011 7(iii) and (iv) 34, 38 14

Part 8 Solutions The marking allocations for many questions have been updated to more realistically reflect exam standards. We recommend you use the 2012 version of the Q&A Bank to see the updated marking allocations. Note however that there has been only one significant change to the contents of the solutions themselves: A bullet has been added to the end of Solution 8.1 part (ii): to provide disclosure information for beneficiaries Part 9 Questions Question 9.3 part (ii) is now worth 4 marks so this question is worth 11 marks in total. Question 9.4 is now worth 3 marks. Question 9.5 is now worth 6 marks. Question 9.7 part (i) is now worth 2 marks so this question is worth 4 marks in total. Question 9.13 part (i) is now worth 8 marks so this question is worth 20 marks in total. Question 9.15 part (ii) is now worth 2 marks so this question is worth 17 marks in total.





2 September 2010 2(ii) 42 2 2 September 2010 6(i), (ii) (v) 40 25 1 April 2011 2(ii) 41 3 1 April 2011 3(i) 39 5 1 April 2011 5(i) (ii) 39 13 2 April 2011 4 43 12

Part 9 Solutions The marking allocations for many questions have been updated to more realistically reflect exam standards. We recommend you use the 2012 version of the Q&A Bank to see the updated marking allocations. Note however that there have been no significant changes to the contents of the solutions themselves: Part 10 Questions Question 10.5 part (ii) is now worth 5 marks so this question is worth 11 marks in total. Question 10.6 part (i) is now worth 9 marks so this question is worth 13 marks in total. Question 10.11 is now worth 5 marks. Question 10.15 is now worth 6 marks. A new question (Question 10.20b) has been inserted: Outline the cost of capital method of determining the risk margin for an economic balance sheet. [6] Question 10.22 is now worth 7 marks.





1 September 2010 2 48 9 2 April 2011 2(ii) 44, 45 6 2 April 2011 5 46 15 2 April 2011 6(iii) 48 5 2 April 2011 7(iv) 48 9

Part 10 Solutions The marking allocations for many questions have been updated to more realistically reflect exam standards. We recommend you use the 2012 version of the Q&A Bank to see the updated marking allocations. Note however that there have only been two significant changes to the contents of the solutions themselves. These are described below. A solution to the new question (Solution 10.20b) has been written. You should insert replacement pages 22b 22c into your Course Notes. In Solution 10.16, the first point under Economic capital available has been extended, and two more points inserted. The first three points of this section now read: Economic capital available The starting point for assessing the economic capital available is for the company to draw up an economic balance sheet, which shows the market value of the company’s assets and the market value of its liabilities. [½] The market value of assets are usually easily and instantly available. [½] The market value of liabities can be determined using a discounted cashflow approach or by using option pricing theory. [½]



4 Changes to the X Assignments

Assignment X1 Solution X1.1

The third point now reads: For example, the risk of poor investment returns and therefore of bonuses being lower than policyholders’ reasonable expectations. [½] Under the Investment section, the second point has been deleted and the first point now reads: Investment Actuaries may advise on an appropriate investment strategy to ensure that the liabilities are met and that bonuses are likely to be in line with policyholders’ reasonable expectations. [1] The section headed “Reinsurance” is replaced with a section about risk management tools and now reads: Risk management tools Actuaries may provide advice on the appropriate risk management tools to use ... [½] ... for example the appropriate levels and types of reinsurance. [½] Solution X1.4

Several points have been added and the marking scheme has been amended. We recommend you remove pages 5 6 use the replacement pages 5 6c provided below. Solution X1.5

The following point has been added to part (ii): the impact on other benefits already provided by the State, eg sickness and

unemployment benefits etc [½] The final point has been deleted from part (ii).



Solution X1.6 The following point has been added to part (iii): company reports and accounts The following point has been added to part (iv): not all of the information may be in the public domain. Solution X1.7 In the section on General economic and commercial environment, the following points have been deleted: relevant legislation / regulation and its impact

solvency requirements and the final point in this section has been extended: The key stakeholders need to be identified and their interests understood, eg shareholders, policyholders. [½] In the section on Developing the solution, the key assumptions now read: Key assumptions will include:

claim frequency distribution

claim amount distribution

claims inflation

volume / mix of business

expenses (including commission) and expense inflation

persistency rates (ie likely renewal rates)

investment returns. [½ each, maximum 2] In the section on Monitoring, the third point has been extended: The monitoring of experience should be carried out more frequently in the early lifetime of the company. Any issues need to be spotted early and acted upon. [½]



Assignment X2 Solution X2.1 Solution X2.1 has been amended. We recommend you remove pages 1 2 and use replacement pages 1 2c below. Solution X2.8 The second point of the solution has been replaced by the following two points: Cover for buildings is on an indemnity basis. [½] Cover for contents can be offered on an indemnity or replacement (“new for old”) basis.

[½] Solution X2.10 A new point has been added immediately before Statutory / regulatory requirements: Existing 40-year-old male non-smokers may cancel their policies and then renew on cheaper rates. This will increase administration expenses. [½] Assignment X3 Solution X3.2 The second paragraph of part (iii) has been replaced with two points: The risk relating to the number of visitors could be reduced by undertaking further research or a feasibility study to gain more precise estimates of the possible future visitor numbers … [½] … or by selling tickets in advance for a wide range of events. [½]



Solution X3.3 In part (i), the second paragraph on page 5 has been expanded. It now reads: This would include:

definition and specification of the development

financial results and assumptions.

risks and mitigation options, including details of residual risks

financing options

possible alternative projects

a recommendation as to whether or not to proceed with the development. [ ½ each, maximum 2]

Solution X3.6 In part (ii), the following point has been deleted: The lack of availability of government bonds may lead to investment in

corporate bonds. [½] Assignment X4 Question X4.5 This question is now worth 8 marks. Question X4.6 This question is now worth 12 marks. Question X4.10 This question is now worth 5 marks. Solution X4.2 The following point has been added to part (i): The exact location of the shops needs to be considered, since this has a

significant impact on how prime the properties are. [½]



Solution X4.4 In part (i) the final point has been deleted and the following two points have been added: The fund may need to maintain significant cash holdings in order to reduce the liquidity risk arising from large encashments ... [½] ... this will dilute the fund’s property portfolio and reduce expected returns. [½] Assignment X5 Question X5.5 Part (ii) is now worth 8 marks, so this question is now worth a total of 15 marks. Question X5.7 Part (i) is now worth 2 marks, so this question is now worth a total of 7 marks. Question X5.8 Part (iii) is now worth 4 marks, so this question is now worth a total of 8 marks. Question X5.9 This question is now worth 6 marks. Solution X5.2 A fourth bullet has been added to part (iv): Technological advances are also likely to increase the volume of trades in the

derivatives market. [½] Solution X5.4 The last four ½ marks on page 5 have been deleted and replaced with: Required return = risk-free real yield +expected inflation + property risk premium [1]



Assignment X6 Question X6.8 This question is now worth a total of 11 marks. Question X6.9 This question is now worth a total of 6 marks. Part (i) now reads: (i) Define the terms:

risk budgeting

strategic risk

structural risk

active risk [2]

Solution X6.2 This solution to part (i) has been significantly amended. We recommend you use remove pages 3 4 and use the replacement pages provided below. Solution X6.5 Two points have been added to the bottom of the solution: Several potentially suitable strategies will be identified and sensitivity / scenario testing carried out to check robustness. [½] The results will then be discussed with the trustees / sponsor. [½] Solution X6.7 In part (ii) the third point under Discretionary benefits has been expanded: Recipients of discretionary benefits are likely to expect a real return. The strategy should be based on the expectations that have built up over time, eg that future discretionary increases should be similar to those awarded in the past. [½]



Solution X6.9 In part (i) the following definition has been added: Risk budgeting is the process of deciding how much risk to take on and where it is most efficient to take the risk, in order to maximise return. [½] Assignment X8 Question X8.4 This has been replaced with a new question. You should remove pages 1 2 and use the replacement pages provided below. Solution X8.2 A new sentence has been added after the first list of bullets in the solution: However, the test should not be so prudent that it affects an insurer’s ability to write business / develop new products. [½] Solution X8.4 You should remove pages 5 6 and replace them with pages 5 6c provided below. Solution X8.5 Part (i) has been amended slightly. The new solution is included on pages 5 6c provided below. Assignment X9 Solution X9.4 The following point has been added to first list of bullets in the solution: moral hazard Solution X9.6 The following point has been added to last list of bullets in the solution: benefits not meeting members’ needs / expectations [½]



Solution X9.7 The following point has been added immediately before the section on Expenses on page 10: There is a risk of selective withdrawals on both contracts. This is likely to be slightly higher on unit-linked contracts since these provide a surrender value. [½] A third paragraph has been added under Expenses: However there will still be some mismatch risk under a unit-linked contract between expenses and charges, eg in terms of nature; some charges relate to investment performance but expenses will be related to price and salary inflation. [½] Solution X9.8 In part (i), the first paragraph under Operational risks now reads: There are operational risks, for example

errors in calculations and projections [½]

incorrect choice of model [½]

time and cost overrun in building and running the model. [½] Assignment X10 Question X10.1 Part (ii) is now worth 3 marks so this question is now worth 6 marks in total. Question X10.4 Part (i) is now worth 5 marks so this question is now worth 9 marks in total. Solution X10.7 In part (ii) the last point on page 12 has been deleted.



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

5.1 Study material We offer the following study material in Subject CA1:

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

CA1 Bitesize

Flashcards

Mock Exam A and Additional Mock Pack (AMP)

Revision Notes

Smart Revise

Sound Revision. For further details on ActEd’s study materials, please refer to the 2012 Student Brochure, which is available from the ActEd website at www.ActEd.co.uk.

5.2 Tutorials We offer the following tutorials in Subject CA1:

a set of Regular Tutorials (lasting five full days)

a Block Tutorial (lasting five full days)

a Revision Day (lasting one full day)

a series of webinars (lasting between one and two hours each) For further details on ActEd’s tutorials, please refer to our latest Tuition Bulletin, which is available from the ActEd website at www.ActEd.co.uk.



5.3 Marking You can have your attempts at any of our assignments or mock exams marked by ActEd. When marking your scripts, we aim to provide specific advice to improve your chances of success in the exam and to return your scripts as quickly as possible. For further details on ActEd’s marking services, please refer to the 2012 Student Brochure, which is available from the ActEd website at www.ActEd.co.uk.



6 Feedback on the study material

ActEd is always pleased to get feedback from students about any aspect of our study programmes. Please let us know if you have any specific comments (eg about certain sections of the notes or particular questions) or general suggestions about how we can improve the study material. We will incorporate as many of your suggestions as we can when we update the course material each year. If you have any comments on this course please send them by email to [email protected] or by fax to 01235 550085.



This page has been left blank so that you can insert the replacement pages into your 2011 Course Notes.

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


3 The professional framework of the Actuarial Profession

The professional framework of the UK actuarial profession comprises both ethical or conduct standards and technical or practice standards.

3.1 Professional conduct standards

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

● integrity

● competence and care

● impartiality

● compliance

● communication. Further details on the new framework can be found on the Institute and Faculty of Actuaries website: www.actuaries.org.uk. Professional skills and detailed consideration of the Actuaries’ Code are covered in detail in a two-day post-qualification course, and actuaries subject to the Continuing Professional Development scheme are required to keep their professional as well as their technical skills up to date. For most actuaries subject to the scheme this includes spending at least 2 hours every year developing professionalism skills and attending a one-day professionalism event at least once every 10 years. Professionalism is essential in setting the scene for the context in which the actuary will operate. The basic principles of professionalism will determine the suitability of solutions to the problems raised. The Actuaries’ Code is therefore essential background to the consideration of the solution to any actuarial problem.

a CA1-01: How to do a professional job


3.2 Technical and ethical standards

These are detailed in Guidance Notes and Technical Actuarial Standards which set out technical or ethical best practice and standards for actuaries to follow. Ethical and professional best practice and standards are the responsibility of the Institute and Faculty of Actuaries, and apply to all members of the profession, regardless of the territory or area of work in which they operate. These are referred to as Actuarial Profession Standards. Actuarial Profession Standards comprise:

the Actuaries’ Code

Actuarial Profession Standards developed since the introduction of the current professional framework in 2006

some of the Guidance Notes from the previous professional framework, which relate to professional and ethical matters.

In the UK, technical actuarial standards are the responsibility of the Board for Actuarial Standards (BAS). This is a body that is independent from the Actuarial Profession: it is an operating body of the Financial Reporting Council. The BAS issues Technical Actuarial Standards (TASs). The aim of the TASs is to ensure that users of actuarial information can have confidence in “the information’s relevance, transparency of assumptions, completeness and comprehensibility”. Technical actuarial standards comprise:

Generic TASs issued by BAS. There are three of these:

− TAS R (Reporting)

− TAS D (Data) and

− TAS M (Modelling).

Specific TASs. These cover practice areas such as:

− insurance (TAS I)

− pensions (TAS P)

− areas of activity such as business transformations (TAS T).

Some of the Guidance Notes from the previous professional framework. It is intended that these will be phased out as they are replaced by TASs.

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

CA1-01: How to do a professional job Page 8b


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

CA1-01: How to do a professional job Page 8c


This page has been left blank so that you can insert the replacement page into your 2011 Course Notes.

CA1-01: How to do a professional job


Communication of the answers in a way that is understood by the client is vital. The means of communicating the answers must be designed to reflect the way the problem-owner listens. It is important to check that that the client has fully understood the answers. The actuary needs to set out the solutions to the client as clearly as possible. Where there are optional solutions they should be presented in an unbiased fashion avoiding pre-judgement as to which is the best solution, unless the actuary is asked to make a clear recommendation. The background to the solution, the assumptions adopted and any areas of risk and uncertainty should be clearly presented. However, care should be taken to avoid making the presentation of this background information so complicated that it becomes confusing and detracts from the solution. If any issues arose in the production of the solution which could reduce the effectiveness or validity of the solution, for example difficulties in obtaining accurate data, the impact of these issues on the solutions put forward should be made clear to the client. In communicating the answers an actuary needs to demonstrate how the answers given help to provide an optimal solution to the problem. Often the answers will give rise to more questions or more problems. The client may need to be guided carefully to the optimal solution. It is important to identify to the client where the original brief ceases and where further questions are giving rise to additional work (and in some cases additional fees). It may also be necessary to give the output a health warning to the effect that the advice is given for a specific audience and may not be appropriate in other circumstances. As with any form of communication, the actuary should know the client and the client’s interests and pitch the language, tone and form of the communication at the appropriate level. In reporting the results of an investigation to a client the actuary should take account of any professional guidance on the content and format of such a report. Professional Implications Throughout any task an actuary needs to consider the professional implications of the work being done.



The Financial Reporting Council has developed an Actuarial Quality Framework which is designed to support effective communication between actuaries, their principal clients and employers such as senior management and members of governing and review bodies, other professionals such as lawyers and accountants, end-users and their representatives, policymakers and regulators. The Framework is intended to be complementary to professional and other regulation affecting actuaries and those who rely on their work. It aims to promote the following drivers of actuarial quality:

● methods - reliability and usefulness of actuarial methods

● communication - communication of actuarial information and advice

● actuaries - technical skills of actuaries and ethics and professionalism of actuaries

● environment - working environment for actuaries and other factors outside the control of actuaries.

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



Chapter 1 Summary Jobs that actuaries do The jobs that actuaries do can be grouped into the areas of:

● risks

● modelling

● managing assets and liabilities

● monitoring experience. Statutory roles In some territories there are statutory roles that can only be taken by actuaries. The statutory roles for actuaries mainly relate to the certification of the adequacy of the valuation of assets and liabilities for a life insurer, general insurer or pension scheme, for example:

● proper records have been kept for valuing liabilities

● proper provision for the liabilities has been made

● assets and liabilities have been valued according to legislative rules

● liabilities have been valued in the context of the assets

● the difference in the assets and liabilities has been stated

● premiums or contributions are adequate to meet future commitments

● professional guidance has been complied with. Actuaries may also work for the statutory body with personal responsibility for various areas of practice or are more commonly employed to check that regulatory objectives are adhered to. Professional framework of the Actuarial Profession Requirements for professional conduct are set out in the Actuaries’ Code, the Actuarial Profession Standards (AP Standards) and Guidance Notes. These are issued by the Board for Actuarial Standards (BAS). The Actuarial Quality Framework aims to promote actuarial quality through methods, communication, actuaries and the environment. It is designed by the Financial Reporting Council and aims to complement professional and other regulation affecting actuaries and their clients.

CA1-01: How to do a professional job


Doing a professional job An actuary must:

● act in a professional manner with integrity and with detachment from his or her own personal circumstances

● develop a direct, personal and trusting relationship with a client in order to advise on the most suitable solution for that particular client

● recognise that others have valid views

● attain and maintain competence in a given field

● be reliable, ie deliver good quality work in a given timeframe

● communicate clearly

● recognise exactly who the client is and what their needs are

● recognise and seek to avoid conflicts of interest. Conflicts of interest Principles to adhere to in managing conflicts of interest include:

● avoidance of the conflict, for example declining to advise one of the parties

● Chinese walls established to ring fence people and data

● disclosure of the conflict to both parties

● keeping detailed records of work assignments

● notifying the regulators if the actuary believes that his/her client is not treating customers fairly.

CA1-03: External environment Page 9


6 Corporate governance

Corporate governance refers to the high level framework within which managerial decisions are made in a company.

Aims The aim of good corporate governance is that a company should be managed in order to best meet appropriate requirements of its stakeholders – the shareholders, employees, pensioners, customers, suppliers and others who may be affected by the company’s operations whilst not having any contractual relationship with the company at any time. One particular concern of attempts to create good corporate governance is that management might make decisions based more on their own personal interests than on those of relevant stakeholders.

Strategies Good corporate governance can be enhanced by ensuring that remuneration incentivises management to act in the interests of stakeholders. Share options may be seen as part of this, though the lack of sufficient downside for management can limit how well share options perform this function. In other words, share option packages may not provide a sufficient incentive to management to control risk. Non-executive directors are also often part of a structure aimed at good corporate governance. The role of the non-executives in corporate governance is to:

● provide an impartial view and represent the shareholders’ interests

● play a leading role in setting the remuneration for executive directors’ pay

● play a leading role in the audit committee, eg in relations with external auditors with no members of the executive present.

The governance arrangements of the product provider have a major influence on the ways in which stakeholder needs are addressed. Guidance on corporate governance is often developed by private institutions as well as by governments. For example, in the UK, the Financial Reporting Council has issued a Code of Practice on corporate governance.

a CA1-03: External environment


For those interested in reading more about corporate governance, we recommend the following SIAS paper (which can be downloaded from the website www.sias.org.uk):

Frost, Alan; Lewis, Malcolm; Taylor, Nick. (2002). Topics in Actuarial and Corporate Governance. SIAS, London.

CA1-03: External environment Page 10b


7 Risk management requirements

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

● credit risk (ie failure of third parties)

● operational risk (ie failures of people, processes and systems within the company)

and specifies methods for calculating capital requirements to cover each of these risks. We will consider these categorises of risk, and others in more detail in later chapters.

c CA1-03: External environment



CA1-14: Bond markets Page 5


1.3 Government bonds: Investment and risk characteristics

The investment and risk characteristics of conventional government bonds should be familiar to you from earlier actuarial subjects.

Question 14.5 (Revision of CT knowledge)

Use SYSTEM T to detail the investment and risk characteristics of conventional government bonds.

The wide variety of conventional government bonds by term and coupon means that they are particularly useful for investors who need to match fixed monetary liabilities.

1.4 Corporate bonds

Investment and risk characteristics The basic features, eg the structure of the cashflows, of corporate bonds are similar to those of government bonds.

Question 14.6

What are the major differences in investment and risk characteristics between government and corporate bonds?

Government securities generally provide the most secure and marketable fixed- interest investment in a particular currency. Therefore investors will require a higher yield on other forms of debt. However, the degree of security offered by government bonds may vary between different governments and depending on economic conditions. For example, whereas bonds issued by most western European governments have historically been perceived as being free of default risk, this has not been true in the case of the governments of smaller or less developed countries. In addition, during the recent economic turmoil even bonds issued by some western European governments such as Greece and Italy have been considered to carry significant default risk. Hence in some instances, the debt issued by a large multinational firm might actually be considered less risky.

CA1-14: Bond markets


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

Yield margins will vary over time. They will tend to be lower when economic conditions are good and the risk of default is low. They will also tend to reflect any differences in tax treatment. Main types of corporate bond The main types of corporate bond are as follows. Debenture A loan made to a company which is secured against the assets of the company. Debentures usually have a floating charge over the assets of the company so that debenture holders rank above other creditors should the company be wound up. Debentures with fixed charges are called mortgage debentures. Unsecured loan stock A form of long-term corporate debt which is not secured on any specific assets of the borrower. If the borrowing company does not meet its obligations, the holders of the unsecured loan stock may sue the company and will then stand alongside other unsecured creditors. To compensate for the higher risk, unsecured loan stock will usually have a higher gross redemption yield than a debenture in a similar company. Subordinated debt This is debt that ranks behind another class (senior debt) for repayment.

CA1-18: Collective investment schemes Page 7


3 Open-ended investment companies (OEICS)

These are an example of a vehicle which is a cross between an investment trust and a unit trust. Like a unit trust, they are open-ended and units are priced at net asset value. However, they are governed by company rather than trust law and entry and exit charges are explicit. One major problem with unit trusts is that the concept of a trust as a legal instrument doesn’t exist in most countries other than the US and UK. Hence unit trusts cannot operate abroad. This led to the introduction of OEICs, which operate in a similar way to unit trusts, but which are structured as companies and hence are legal in all countries. The main features of OEICs are that: ● They are companies governed by company law, as opposed to trusts, like

investment trust companies.

However, they can create and cancel share capital at will – ie they are open-ended like unit trusts.

● They have limited powers to borrow (ie gearing). ● A single company can offer several different funds. Only one corporate

structure is required, however, unlike unit trusts where each fund has a separate status (as a trust). Thus, the investor first chooses which OEIC in which to invest and then chooses the fund or funds within that OEIC in which to invest.

● This should reduce the management costs as compared to unit trusts – ie as part

of the management costs are effectively spread over several funds. ● The restrictions on the assets in which OEICs may invest are the same as for unit

trusts – ie in tradable securities as defined under a European directive. This means that the value of the underlying assets can be determined objectively (by reference to the observable list price) and the price of the shares can therefore be seen to be fair to the shareholders.

● There is a single price for both buying and selling, which is equal to the net asset

value of the underlying investments. All charges and commissions are shown / deducted separately. This offers greater transparency to investors.

CA1-18: Collective investment schemes


4 Differences between closed-ended and open-ended funds

The differences between investment trusts and unit trusts can be summarised as follows: ● The marketability of the shares of closed-ended funds is often less than

the marketability of their underlying assets. The marketability of units in an open-ended fund is guaranteed by the managers.

● Gearing of closed-ended funds can make the shares more volatile than

the underlying equity. Most open-ended funds cannot be geared and those that can may only be geared to a limited extent.

This increased volatility of closed-ended funds means that they should provide a higher expected return.

● Shares in closed-ended funds are also more volatile than the underlying

equity because the size of the discount can change. The volatility of units in an open-ended fund should be similar to that of the underlying assets.

● At any point in time there may be uncertainty as to the true level of net asset value per share of closed-ended funds, especially if the investments are unquoted.

● Management charges are usually higher for open-ended funds than

closed-ended funds. ● Closed-ended funds may be able to invest in a wider range of assets than

unit trusts. ● It may be possible to buy assets at less than net asset value in a closed-

ended fund. ● They may be subject to tax at different rates.

CA1-19: Overseas markets Page 3


Fair return for risk Overseas investment is riskier. For example, investing in the USA involves a currency risk for an investor with sterling liabilities. However, investing in the UK gives an investor with dollar liabilities a currency risk. The fair compensation for higher risk can’t really apply in both these cases, and may not apply in either, ie you cannot expect to earn a higher return from overseas investment just because it is risky to you. However, you may get fair compensation for risk when the market itself is riskier. For example, both Japanese and US investors might expect higher returns from investing in Japan than from investing in the US because the Japanese stock market has tended to be more volatile than the US market. Market inefficiencies If all of the world’s investors knew that a particular country was about to be highly successful, then the price of buying investments in that country would already be high, and the expected returns might be no greater than available elsewhere. Investing in an economically strong country should give better returns only if the economy is more successful than the markets had expected, ie if the market was inefficient.

1.3 Diversification

A major benefit of overseas investment is diversification. Investing in a number of different countries or economies with a low degree of correlation helps to reduce risk. Diversification is also achieved by investing in industries that are not available for investment in the home market and gives a larger number of companies from which to construct a diversified portfolio. Put simply, a fund that invests in more than one country is less vulnerable to a downturn in the economic fortunes of any single country. This is because investment markets in different countries are not perfectly correlated. Consequently, a fall of 10% in stock market X does not imply that there will be a 10% fall in stock market Y.

Question 19.1

How specifically do overseas investments help diversify a portfolio?

a CA1-19: Overseas markets


2 Problems of overseas investment

Overseas investment is not entirely good news. The problems with overseas investment are summarised below.

2.1 Adverse currency movements

Investing overseas means that investors with domestic liabilities are accepting a mis-match, at least in the short term. Furthermore, currency movements lead to extra volatility of the total returns. These problems can sometimes be wholly or partially overcome by hedging the exchange risk. Hefty losses can be made very quickly if the currencies purchased fall in value. Similarly, losses in domestic currency terms are made if the domestic currency rises in value. You might be surprised at how volatile even major currencies can be.

Examples Problems in the US economy (eg in the sub-prime housing market) saw the £ increase in value from $1.75 in 2005 to over $2 in 2007, before similar economic problems hit the UK and the £ weakened. After the Japanese tsunami in March 2011, the Yen increased by 8.6% within just a few days. This is because it was anticipated that Japanese insurers would be forced to sell their overseas assets in exchange for Yen, in order to pay claims. This would have had a strengthening influence on the Yen, but the impact was accelerated and exaggerated because overseas investors anticipated this move and bought Yen themselves in an attempt to take advantage of the expected increase.

2.2 Taxation

Taxation varies from country to country. It may not be possible to recover withholding taxes imposed on overseas investments. Overseas investment will often result in higher overall tax charges for the investor. Withholding tax is tax deducted at source from dividends or other income paid to non-residents of a country. The investor could then be liable for further tax in his or her own country.

CA1-19: Overseas markets Page 4b


The adverse effect of this will be reduced where there is a double taxation agreement between the domestic tax authorities and the particular overseas country, as this means that the domestic tax is reduced or even eliminated because of the overseas tax already paid.

c CA1-19: Overseas markets



CA1-37: Accounting and disclosure Page 1


Chapter 37

Accounting and disclosure

Syllabus objectives (8.3.1) Describe the reports and systems, which may be set up to control the progress of

the financial condition of the main providers of benefits on contingent events.

0 Introduction

This chapter looks at the principles underlying the financial statements of financial service providers. It starts with a reminder of the accounting concepts and principles that apply to all businesses, before going on to look at the financial reporting requirements of insurance companies. Finally reporting and disclosure requirements for benefit schemes are considered.

CA1-37: Accounting and disclosure


1 Accounting concepts and principles

Accounting concepts and principles may vary from country to country, although efforts are being made to achieve greater harmonisation of international accounting practice. The principles used may also depend on the purposes for which the accounts are designed. In recent years Accounting Standards have placed greater emphasis on neutrality, rather than prudence, and there has also been a move away from historical cost towards “fair values”. In very broad terms, this means revaluing assets (and liabilities) in the statement of financial position at the end of each accounting period. Any loss on revaluation should be included in that period’s income statement. Any gain on revaluation is taken to the revaluation reserve in the statement of the financial position, where it is held until the gain is realised (ie the asset is sold). A consequence is volatility in the financial statements and so this move is controversial. The following accounting concepts were introduced in Subject CT2 – Finance and financial reporting:

cost

money measurement

going concern

business entity

realisation

accruals

matching

dual aspect

materiality

prudence

consistency. If you are unfamiliar with some of these terms, you may like to revisit the material in Subject CT2 now.

Question 37.1

State what is meant by the going concern, accruals, consistency and prudence concepts.



Exam tip Candidates are not expected to be familiar with the accounting concepts and principles that apply in any particular country. They may be expected to discuss problems that arise in defining accounting concepts and principles and putting them into practice, and the implications for the interpretation of providers’ accounts.

Question 37.2

“Although accounting concepts appear reasonable in isolation, conflicts between them can arise in putting them into practice.” Give examples of possible conflicts.

Question 37.3

A financial service provider’s accounts may be analysed by various parties including:

shareholders

loan creditors

competitors

regulator

tax authorities. What degree of prudence is each of these users of the accounts likely to find the most helpful?



This page has been left blank so that you can insert the replacement pages into your 2011 Course Notes.



Chapter 37 Summary Accounting concepts Although regulation and practice may vary between countries, the main accounting concepts commonly used in drawing up financial statements are:

cost

money measurement

going concern

business entity

realisation

accruals

matching

dual aspect

materiality

prudence

consistency. Interpreting accounts In analysing accounts, attention should be paid to:

any accounting rules, guidance and practice in the country concerned

whether the accounts should be prepared on a going concern basis and should give a true and fair view

any changes in accounting practice

the basis used for the valuation of assets

any exceptional events during the accounting period. Insurance companies Insurance business is subject to cyclical effects, which means that the results of one insurance company should only be compared to those of companies transacting similar types of business. The strength of the provisioning basis will affect the reported results, which makes it difficult to achieve consistency from year to year.



Accounts can be analysed using ratios including the: expense ratio

commission ratio

operating ratio

ratio of outward reinsurance premiums to gross premium income. Benefit schemes Reporting on the progress of benefit schemes is different as benefit schemes do not generate profits or losses. In many countries, information about the financial position of the scheme must be disclosed to beneficiaries in an attempt to improve the security of the provisions. It is important that beneficiaries are given sufficient information about their entitlements. Disclosure could include details of the:

benefit entitlements

contribution obligations

expense charges

investment strategy

risks involved

treatment of entitlements in the event of insolvency. Where disclosure is required by regulation, this may relate to information given to beneficiaries:

on entry

at regular intervals

once payments commence

on request

a combination of these. Also, where benefits are sponsored by a company, it is important that the company’s shareholders are aware of the financial significance of the benefit obligations that exist. It is therefore common practice in many countries for these financial obligations to be shown as part of the company’s accounts.



Chapter 37 Solutions Solution 37.1

The “going concern” concept assumes that the enterprise will continue in operational existence for the foreseeable future. The “accruals” concept states that revenue and costs should be recognised as they are earned or incurred, not as money is received or paid. The “consistency” concept states that there should be consistency of accounting treatment of like items within each accounting period, and from one period to the next. The “prudence” concept states that revenue and profits should not be anticipated, and provision should be made for all known liabilities, whether the amount of these is known with certainty or not. The greater the uncertainty in the value of the liabilities, the greater should be the tendency to aim at technical provisions exceeding the expected value of the liabilities. Solution 37.2

Examples of conflicts between the concepts include: going-concern and prudence – eg giving a non-zero value to a piece of

machinery that would have zero resale value prudence and accruals – eg taking credit for payment from a customer even

though it has not yet been received. Solution 37.3

Shareholders are likely to want a realistic view of the performance of the company to enable them to make correctly informed decisions. Loan creditors are less concerned with the level of profitability of the company and more with the certainty with which the company can make their loan repayments. They would possibly prefer a slightly more prudent view than shareholders. Competitors are likely to be interested in realistic information. The regulator is likely to be primarily concerned with the solvency of the company so would prefer more prudence than most other users.



Tax authorities will want as little unnecessary prudence as possible if it reduces or defers company profits and hence tax. Solution 37.4

Possible reasons for the reduction in the ratio include: The insurer has lowered its commission levels with no change in premium rates

or sales. For example, it might have changed to a greater element of non-commission remuneration for selling its business.

The mix of business may have changed in some way. For example, selling more

business from a sales channel which is paid lower commission or selling a greater proportion of products which have a lower commission rate than others.

Commission payments and the commission loading in the premiums are lower

by the same amount with no reduction in sales. The ratio will reduce because of the gearing effect. For example if the previous year saw commission of £20m and premium income of £100m and this year saw a £3m reduction in both commission and premium income, the ratio would fall from 20% to 17.5%. Given the size of the fall in the ratio this is unlikely to be the only explanation, especially as you might expect lower commissions to reduce sales volumes.

Solution 37.5

For short-term classes of business most of the cashflows occur in a single year and the major ones are premiums, claims and expenses. Therefore, the operating ratio can give a meaningful measure of the profitability of a company. For long-term insurance the cashflows are spread over a greater time period and include the maintenance of appropriate provisions over this time period and so an analysis of amounts over an accounting period is not particularly enlightening.

CA1-45: Risk management tools (2) Page 5


2.3 Life insurance underwriting

The initial underwriting process for a life insurer involves:

● medical underwriting – assessing the applicant’s health

● lifestyle underwriting – assessing the impact of lifestyle (eg occupation, leisure pursuits, country of residence) on the level of risk

● financial underwriting – to reduce the risk of overinsurance, as described above. Medical and other evidence Where the company is at risk on death or sickness under a contract, it will obtain evidence about the health of the applicant so as to assess whether he or she attains the company’s required standard of health and if not what their state of health is relative to that standard. For annuities and other contracts where there is only a longevity risk, the same could be done, but with a different emphasis, if the company intends to differentiate according to the health of the applicant in the terms it offers. For example, ill-health (or impaired lives) annuities are now increasingly common, eg in the UK and the US. The emphasis of these contracts is more to improve the marketability and fairness of the contracts than to control risk. For example, a person who is in poor health would not consider applying for an annuity unless some special rates were to be offered. In this case, the insurer would grant a higher level of annuity payment on the expectation that the payments would continue for a shorter time. An example would be an annuity contract where better rates were to be offered to smokers than to non-smokers.

Question 45.4

What are the risks of offering preferential annuity rates to smokers?

An insurer will assess the longevity and health risks of a prospective policyholder by:

● asking questions on the proposal form

● obtaining reports from a policyholder’s doctor(s)

● carrying out a medical examination

● performing specialist tests on the applicant.

CA1-45: Risk management tools (2)


Question 45.5

What questions would be asked on a typical life insurance proposal form? (Hint: think about questions relating to medical information, lifestyle and financial information.)

Question 45.6

How big a risk to the insurer do you think applicant dishonesty is in answering such questions?

The more information an insurer obtains about each applicant the greater the proportion of high-risk applicants that will be identified. This means that more extra premiums will be received for the same policyholders, but at a higher underwriting cost. Therefore the insurer must weigh the advantages of medical underwriting against the extra costs involved. The insurer would normally look at market practice in setting the medical limits at which the various tests are triggered or seek its reinsurer’s advice. Lifestyle underwriting Besides the medical state of health of the applicant, other factors that can affect the mortality or sickness risk need to be investigated, namely any risks associated with the:

● applicant’s occupation

● leisure pursuits of the applicant

● applicant’s normal country of residence.

Question 45.7

What factors, relating to the applicant’s normal country of residence, influence mortality risk?

Financial underwriting To counter the risk of overinsurance, details of the financial health of the applicant may be obtained.



Interpretation of the evidence The evidence obtained needs to be interpreted in terms of the standard of health required by the life insurance company. This will be done by specialist underwriters employed by the company. The proposal form will be initially reviewed by administrative staff. They will look through the answers, converting the numerical fields (such as height and weight, or units of alcohol consumed) into “OK / not OK” by reference to some simple tables prepared by the company’s specialist underwriters. Most proposals will be “OK” on all fronts, and can then be processed immediately. Those proposals for which queries have been raised will be passed on for further consideration. Many of the proposals may then be dealt with by an underwriter making reference to a (paper or computer-based) manual from a reinsurer. Such manuals are a good example of the types of technical assistance that reinsurers provide. Particularly unusual or large cases may be referred to a doctor employed by the provider for this purpose. Specification of terms Applicants whose state of health reaches the required standard can be offered the company’s normal terms for the particular contract. Other applicants will be offered special terms, unless their state of health is such that the company will not accept them on any terms, in which case they will be declined – at least temporarily.

Question 45.8

If someone is a bad risk, how does temporarily declining help? Won’t they still be a bad risk at the end of the period they are declined for?



Key information The main ways in which the special terms can be specified are as follows:

● An addition may be made to the premium that would have been charged to an applicant who did meet the required standard, commensurate with the degree of extra risk.

● A deduction may be made from the benefit, which would have been paid to an applicant who did meet the required standard, again commensurate with the degree of extra risk.

● An exclusion clause may be appended to the contract, which excludes payment of benefit claims that arise due to specified causes.

The exclusion clause will normally be the least preferred option, since if a policyholder requires cover for some reason, such as providing an income for a widow(er) and family, a policy with an exclusion clause would not be meeting fully the policyholder’s insurance need. In fact, the policy is providing no cover for what is almost certainly going to be the most likely cause of death, and it is likely that adverse publicity would follow the enforcement of exclusion clauses in practice. Another significant difficulty with exclusions is that they are very difficult to enforce at the time of claim. Officially recorded causes of death can be vague or ambiguous.

Question 45.9

For the following contracts, which special terms are likely to be the most suitable:

(i) regular premium endowment assurance

(ii) regular premium income protection.



Chapter 45 Summary Diversification Risk can be managed through diversification within the following:

● lines of business

● geographical areas of business

● providers of reinsurance

● investments – asset classes

● investments – assets held within a class. Diversification can also be achieved by entering into reciprocal reinsurance arrangements. Underwriting at the proposal stage Underwriting generally refers to the assessment of potential risks so that each can be charged an appropriate premium. Underwriting can be used to manage risk in the following ways:

● It can protect a provider from anti-selection.

● It will enable a provider to identify risks for which special terms need to be quoted.

● For substandard risks, the underwriting process will identify the most suitable approach and level for the special terms to be offered.

● It will help to ensure that all risks are rated fairly.

● It will help in ensuring that claim experience does not depart too far from that assumed in the pricing of the contracts being sold.

● For larger proposals the financial underwriting procedures will help to reduce the risk from overinsurance.

Life insurance initial underwriting is likely to involve the following:

● medical underwriting – assessing the applicant’s health

● lifestyle underwriting – assessing the impact of lifestyle (eg occupation, leisure pursuits, country of residence) on the level of risk

● financial underwriting – to reduce the risk of overinsurance, as described above.



The evidence needs to be interpreted by specialist underwriters. Applicants whose state of health reaches the required standard can be offered the company’s standard terms for the particular contract. Other applicants will be offered special terms, which might include:

● an addition to the premium

● a reduction to the benefit

● an exclusion clause

● declining the applicant (either on a temporary or permanent basis). Claims control systems Claims control systems mitigate the consequences of a financial risk that has occurred by guarding against fraudulent or excessive claims. Management control systems Management control systems include:

● data recording

● accounting and auditing

● monitoring of liabilities taken on

● options and guarantees. Managing options and guarantees Techniques for managing options and guarantees include:

● liability hedging

● immunisation

● derivatives purchased over-the-counter

● option pricing methods.

CA1-47: Capital management (2) Page 11


2.2 Economic balance sheet

The basic economic balance sheet The first stage in a risk-based capital assessment for a provider is to produce an economic balance sheet.

Key information An economic balance sheet shows:

● the market values of a provider’s assets (MVA)

● the market values of a provider’s liabilities (MVL)

● the provider’s available capital, which is defined as MVA – MVL. The available capital is then compared with the economic capital requirement to assess the provider’s solvency status.

Market value of assets

Market value of liabilities

Available economic

capitalEconomic

capital requirement

Free capital

Market values of assets are usually easily and instantly available from the financial markets. The determination of a market value for a provider’s liabilities is not so easy and a high level of judgment is required to determine market-consistent liability values. One approach is to determine the expected value of the unpaid liabilities stated on a present value best estimate basis and to add a risk margin. The risk margin could be determined using the “cost of capital” approach, which is described further below. An alternative approach is to use option pricing theory, the detail of which is outside the scope of this course.

a CA1-47: Capital management (2)


The value of using an economic balance sheet as a starting point for capital requirement assessment is that it starts with assets and liabilities both being assessed on the same, market-consistent, basis. Other methods that involve a deterministic valuation of liabilities necessarily use a basis that does not set out to be market-consistent. In particular most liability valuation bases used for supervisory purposes have an inbuilt prudential margin, to a greater or lesser extent, depending on the regulatory regime. The risk margin: “cost of capital approach” In summary, the “cost of capital” method for determining the additional risk margin is as follows:

firstly project the required capital at each future time period (ie the amount required in excess of the projected liabilities)

multiply the projected capital amounts by the cost of capital

discount using market consistent discount rates to give the overall risk margin. This is discussed in more depth below: As mentioned above, one approach that can be used to determine the risk margin component of an economic balance sheet is the “cost of capital” method. This involves first projecting forward the future capital that the company is required to hold at the end of each projection period (eg year) during the run-off of the business. The projected capital is determined according to the chosen regulatory basis (eg Solvency II SCR), and is the amount required to be held in excess of the projected liabilities at each period. These projected capital amounts are then multiplied by a cost of capital rate. This rate can be considered to represent the cost of raising incremental capital in excess of the risk-free rate, or alternatively it represents the frictional cost to the company of locking in this capital to earn a risk-free rate rather than being able to invest it freely for higher reward. It may for example be determined as the excess of the weighted average cost of capital over the risk-free rate, and hence may be term dependent. In some calculations it is a specified fixed rate (eg 6% per annum in Solvency II).

CA1-47: Capital management (2) Page 12b


The product of the cost of capital rate and the capital requirement at each future projection point is then discounted, using market consistent discount rates, to give the overall risk margin:

Risk margin = ( )1

t tt

tt

k C

r

¥

+

Â

where tk is the cost of capital “charge” for time t, tC is the required capital at

time t and tr is the risk-free interest rate for maturity t. For some chosen regulatory frameworks the projection of required capital can be relatively straightforward, for example where it is defined as a fixed percentage of reserves. However, for others it can be complicated if the calculation of required capital itself requires projections, stochastic modelling and/or application of correlation matrices.

In such situations, a simplified approach can normally be used. This might involve selecting a driver (eg reserves or sum at risk) which has an approximately linear relationship with the required capital or its components. By “sum at risk”, we mean the difference between the benefit and the reserve held. The initial capital requirement can be expressed as a percentage of that driver, and the projected capital is then approximated as the same percentage of the projected values of the driver. In practice, more sophisticated methods using a combination of drivers and correlations may have to be used.

CA1-47: Capital management (2) Page 12c



CA1-47: Capital management (2) Page 19


In an economic balance sheet:

● assets and liabilities should be valued at market rates, and the excess of the assets over liabilities (ie the available capital) should be compared to the economic capital requirement

● one way to calculate the market value of liabilities is to use the present value best estimate basis and add on a risk margin.

The cost of capital approach may be used to determine this risk margin:

● firstly project the required capital at each future time period (ie the amount required in excess of the projected liabilities)

● multiply the projected capital amounts by the cost of capital

● discount using market consistent discount rates to give the overall risk margin. Internal models Internal models are used to calculate economic capital requirements and may be used to determine the Solvency II SCR (provided the internal model gains regulatory approval). Internal models aim to create a stochastic model that reflects a company’s own business structure. Companies can use internal models:

● to calculate economic capital using different risk measures, eg VaR and TailVaR

● to calculate levels of confidence in the level of economic capital calculated

● to apply different time horizons to the assessment of solvency and risk

● to include other risk classes not covered in the standard model.

CA1-47: Capital management (2)


This page has been left blank so that you can keep the chapter summaries together for revision purposes.

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


Solution 1.16

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

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

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

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

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

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

● The employer may be part of a multi-employer scheme that provides benefits. [½] [Maximum 4] Solution 1.17

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

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

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

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

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

● … to prevent insider trading and fraud [½]

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

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

● appropriate procedures exist for admitting new listings [½]

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

● … to prevent fraud. [½] [Maximum 6]

CA1: Q&A Bank Part 1 – Solutions


Solution 1.18

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

● the Actuaries’ Code [½]

● Actuarial Profession Standards (AP Standards) [½]

● some of the Guidance notes from the previous professional framework. [½] Professional skills and consideration of The Actuaries’ Code are covered in detail in a two-day post-qualification course. [½] Actuaries subject to the continuing professional development scheme are required to keep their professional as well as their technical skills up to date. [½] The Board for Actuarial Standards (BAS) issues Technical Actuarial Standards (TASs). These can be on either specific or generic topics, and are gradually replacing the Guidance Notes. [½] The TASs apply to work done in relation to UK operations of entities and any non-UK operations which report in the UK. [½] The aim of the TASs is to ensure that users of actuarial information can have confidence in “the information’s relevance, transparency of assumptions, completeness and comprehensibility”. [1] Actuaries may only depart from these standards if the departure is not considered to be material. [½] [Maximum 4]

CA1: Q&A Bank Part 1 – Solutions Page 17


– reduced product innovation – due to the additional costs of complying with the regulatory requirements [½]

– reduced competition – again due to the additional constraints imposed by the regulations on the providers of financial services. [½]

The optimal level of regulation is that at which the marginal costs and benefits of regulation are equal. [1] [Maximum 7] (ii) Why different regulations in the retail and wholesale markets ● Institutional investors (who invest in the wholesale markets) will typically have

access to a much greater level of information than personal investors ... [½]

● ...and will in any case normally have more investment expertise. [½]

● Consequently, there is usually a much greater regulatory requirement to ensure the provision of appropriate information in the retail market. [1]

[Total 2] Solution 1.21

Legislation

The State may require companies shipping radioactive materials to take out such insurance. [½]

The insurer should ensure that the details of the proposed product meet the minimum requirements required by the State. [½]

Competition

The insurer should look whether competitors provide similar cover and at what price. [½] If possible, the product should include valuable features or options that are not present in competitors’ products. [½]

Underwriting cycle

The launch of the product should be timed to be at the top of the cycle ... [½]

...so as to maximise profits in the initial phase. [½]

CA1: Q&A Bank Part 1 – Solutions


Capital adequacy and solvency

This product should be designed in such a way that the capital requirements are not too onerous. [½]

For example, the pre-agreed limit should not be ridiculously high. [½]

Risk requirements

Key risks should be identified, for example:

● business risks – the risks of higher than expected numbers of claims or claim amounts from leakages, risk of a catastrophic radio-active disaster

● credit risks – defaults from reinsurers, the shipping company (premiums)

● market risks – poor investment returns

● operational risks – fraud

● external risks – terrorism, war. [½ for each risk, maximum 1]

Social trends and lifestyle considerations

The pricing of the product should take into account its potential lifespan. [½]

For example, if nuclear power is to become unattractive (commercially or otherwise) then the lifespan, over which initial costs are to be recovered, may be short. [½]

Environmental issues

The association with the nuclear industry may present challenges. The views of certain key stakeholders might need to be considered before launching such a product. [½]

For example, if key corporate shareholders of the insurance company are anti-nuclear, then the launch of such a product might be opposed. [½]

International practice

The design of similar insurance products offered by insurers in overseas markets should be considered for ideas when setting the terms for the product. [1]

Technological changes The product should be capable of being marketed, sold and administered using up-to-date technology such as the internet. [1] [Maximum 8]

CA1: Q&A Bank Part 10 – Solutions Page 22b


Solution 10.20b

Determining the risk margin in an economic balance sheet Projection of capital The cost of capital method involves first projecting forward the future capital that the company is required to hold at the end of each projection period (eg year) during the run-off of the business. [½] This is the amount required to be held in excess of the projected liabilities at each period. [½] Calculation of the projected capital might require complex projections, stochastic modelling and/or correlation matrices ... [½] ... and should be determined according to the relevant regulatory basis (eg Solvency II SCR). [½] Cost of capital charge These projected capital amounts are then multiplied by a cost of capital rate. [½] This rate represents the cost of raising incremental capital in excess of the risk-free rate ... [½] ... or alternatively it represents the frictional cost to the company of locking in this capital to earn a risk-free rate rather than being able to invest it freely for higher reward.

[½] It can be calculated as the excess of the weighted average cost of capital over the risk-free rate. [½] It may be dependent on the time period being considered ... [½] ... or it may be a specified fixed rate (eg 6% per annum in Solvency II). [½] Overall risk margin The overall risk margin is then calculated as: [½]

c CA1: Q&A Bank Part 10 – Solutions


risk margin = ( )1

¥

+

Â t tt

tt

k C

r

● where tk is the cost of capital charge for time t [½]

● tC is the required capital at time t and [½]

● tr is the risk-free interest rate for maturity t. [½]

[Maximum 6]

CA1: Assignment X1 Solutions Page 5


These key risks are that:

● investment returns are lower than expected [½]

● longevity improves during the period before retirement and this is reflected in increases in the price of annuities (assuming an annuity is purchased at retirement) [½]

● expenses are higher than expected (although this risk is only removed if expenses are met from the member’s account, as opposed to separately by the employer). [½]

[½ for each risk, maximum 1]

In transferring these risks, upside as well as downside risks is passed to the employees, so the sponsor can no longer benefit from these. [½]

However, many risks will still be borne by the employer. [½] From the employer’s perspective, the contribution rate (eg 10% of salary) can be known with certainty, but the actual cost is not known since it depends upon the: [½]

● number of members in the scheme at any point in time [½]

● level of salary increases awarded. [½] (Although these factors are to a degree under the control of the employer they are still not known with certainty.) There are also risks that payments may be required at an inopportune time – note that the employer must pay contributions on the day that they are required in order for contributions to earn sufficient investment return until retirement. [1] There is the risk that if resulting member benefits were very poor:

● the employer might come under pressure to increase contributions in the future [½] ● members may not be able to afford to retire, leading to bad publicity for the

employer (ie reputational risk). [½] There may be a DB underpin, in which case not all the risk is passed to employees. [½] In addition the employer is open to the risk that:

● funds might be lost due to fraud or misappropriation [½]

● there are errors in administration, eg incorrect allocation of contributions to investment funds [½]

a CA1: Assignment X1 Solutions


● any advice provided might be incorrect, leading to repercussions for the employer [½]

● any administrative costs met by the employer (eg the cost of compliance) might be greater than expected [½]

● inappropriate decisions might be made by trustees with repercussions for the employer [½]

● it may be harder to attract / retain good quality staff [½]

● there might be breaches of regulations leading to fines or loss of tax status [½]

● there might be changes to regulations or tax status which affect the cost of the scheme. [½]

[Maximum 7] Solution X1.5

(i) Stakeholders the Government

regulators

existing pensioners

current workers

other members of the population (for example unemployed, carers)

employers in the country

trustees of occupational pension schemes

personal pension providers

administrators of State-sponsored benefits

auditors

operators of the investment markets including financial institutions and investment managers

overseas governments [½ each, maximum 5]

CA1: Assignment X1 Solutions Page 6b


(ii) Review of the external environment This will involve considering:

the objectives of the Government, eg to provide an adequate pension for all or just to act as a safety net for the needy [½]

the current approach to retirement provision [½]

CA1: Assignment X1 Solutions Page 6c





Assignment X2 Solutions

Solution X2.1

When structuring your answer to this question, it is a good idea to first identify the risks that are common to all four products, in order to avoid repetition. General risks on all four contracts ● The insurance company may become insolvent. [½]

● The insurance company may fail to deliver on its contractual obligations. [½]

● Circumstances may change, but the policy is not flexible enough to accommodate the customer’s new needs. [½]

(i) With-profit endowment ● Bonuses may not be as large as expected … [½]

● … and the mortgage loan may not be fully repaid by the maturity proceeds from the endowment. [½]

● Surrender benefits may not be as high as expected, eg if the policy is surrendered and the mortgage is repaid early. [½]

(ii) Without-profit convertible term assurance ● Conversion terms may not be as favourable as expected, eg they are on rates set

at the outset of the policy and these are now not competitive … [½]

● … or conversion terms may now be unsuitable for the policyholder, eg if their circumstances have changed. [½]

● At conversion, the level of cover may need to be increased, but this can only be done subject to underwriting. [½]

● The same total benefits could have been obtained more cheaply via a with-profit or unit-linked policy or via a brand new contract. [½]

● The (fixed) benefit may be eroded by inflation. [½]



(iii) Unit-linked immediate annuity ● There is a risk that the annuitant dies early in the policy thus obtaining poor

value for money. [½]

● Unit prices are volatile and thus the level of annuity may not always meet the annuitant’s needs. [½]

● The underlying investments may not perform as well as expected, resulting in annuity payments being lower than expected. [½]

● Charges may be higher than expected, leading to lower annuity payments than expected. [½]

(iv) Index-linked critical illness plan ● A severe illness may be suffered that is excluded from the contract. [½]

● The index may not track the value of the risk (liability) for which it was intended as insurance, eg the policyholder may want the level of cover to increase in line with earnings, where as the policy may be linked to a price inflation index. [½]

● The linked assets may perform badly, adversely affecting the value of the benefit. [½] [Maximum 8]

Solution X2.2

(i) Indemnity “Indemnity” is compensation / reimbursement for a loss. The idea is that the insured is restored to the same financial position as before the loss occurred. [1] (ii) Products not providing indemnity ● Personal accident, where the insured may be paid a fixed amount per limb lost.

● Health insurance, where the insured may be paid a fixed amount regardless of the actual cost of treatment.

● Unemployment insurance, where the insured will only receive benefits for a maximum period of time, regardless of how long they are unemployed.

● “New for old” policies under domestic contents, where the insured receives compensation greater than the value of the lost contents.



● Any insurance policy with an element of self-insurance, eg where there’s an excess (or a maximum level of cover).

[1 for each distinct product and explanation, maximum 3]

CA1: Assignment X2 Solutions Page 2c





(ii) Factors leading to a tactical switch The key reason would be to enhance returns. [½] Changes in the outlook for particular assets (eg due to expected interest rate movements, inflation, economic growth, currency movements) that do not appear to be correctly allowed for by changes in market valuations (eg in redemption yields, PE ratios, running yields, currencies) provide scope for tactical switches. [1] Similarly, changes in valuations that are not justified by changes in the investment outlook provide scope for tactical switches. [½] Problems of making a tactical switch for a large portfolio

The main problems when making large changes to the asset allocation are the:

● possibility of shifting market prices adversely (both on sale of existing portfolio and purchase of new assets). Large switches may well shift market prices. [½]

● time needed to effect the change and the difficulty of making sure that the timing of deals is advantageous [½]

● dealing costs involved [½]

● possibility of the crystallisation of capital gains leading to a tax liability. [½] [Total 4] Solution X6.2

To score really well on these investment strategy questions, you need to think through the SYSTEM T characteristics of the asset involved … … as well as considering factors in the chapters relating to investment strategy … … and apply your answer to a wealthy individual. (i) Conventional government bonds vs ordinary shares vs property for a wealthy

individual investor Ordinary shares and property should usually offer a higher expected return than government bonds. [½] A wealthy individual, who is not particularly risk-averse, may be happy to go for the higher risk / higher return options of ordinary shares and property. [½]

CA1: Assignment X6 Solutions


Ordinary shares and property are also much riskier than bonds in terms of the volatility of market values and the risk of default. [½] A wealthier investor may be able to tolerate such risks. [½] Ordinary shares and, to an even greater extent, property are less marketable than government bonds. The investor needs to consider whether the income stream is sufficient for their needs or whether assets will need to be realised. [½] The investor will be seeking diversification. Government bonds provide a fixed nominal return, and hence diversification from the real nature of the returns received from ordinary shares and property. [½] Ordinary shares and property should offer a degree of protection against inflation, at least over the long term. An individual’s liabilities are likely to be primarily real in in nature, so ordinary shares and property will be a good match. [½] With conventional government bonds there is a danger that unexpectedly high inflation will erode the investor’s real wealth. [½] Ordinary shares (and most properties) give a lower running yield than government bonds. [½] This means that there is less need for reinvestment of income ... [½] ... the investor needs to consider his/her cashflow requirements, and therefore the need for high or low running yield investments. [½] It may also be advantageous to hold lower running yield investments from a tax perspective, eg if income is subject to a higher rate of tax than capital gains. [½] Property may provide the investor with a higher utility (or feel good) value. [½] Individuals may also choose to invest in property for their own use. [½] Property investment requires more expertise, the individual is unlikely to have this. [½] Property also allows the investor to gear up by borrowing against the value of the property if so desired. [½] Property is less divisible and hence it is harder to achieve diversification, even for a wealthy individual. [½] [Maximum 7]

CA1: Assignment X8 Questions Page 1


Question X8.1

Outline briefly the consequences to a proprietary insurance company of overestimating or underestimating provisions. [5] Question X8.2

A developing country is considering regulation of the adequacy of general insurers’ provisions. It has been suggested that insurers hold an extra cushion of assets (assessed at market value) equal to the maximum of:

● 20% of provisions held to meet claims and expenses and

● 500,000 currency units, to be revalued in line with inflation. State the likely aim of this regulation and comment on the likely suitability of this test as a test of adequacy of provisions and suggest any improvements that might be made. [14] Question X8.3

Outline the factors that determine the degree of prudence (and use of margins) in the actuarial assumptions used in the valuation of a defined benefit pension scheme. [9] Question X8.4

You are an actuary for a large general insurer which writes a range of lines of business and is looking to grow by expanding into an overseas country. The company has identified a small insurer operating in that country, and is considering purchasing it. You have been asked to provide an initial analysis of its accounts. (i) List the key accounting ratios you would want to calculate when analysing the

insurer’s financial condition and the profitability of its business. [3] (ii) Outline the considerations that should be taken into when interpreting the

accounts. [6] [Total 9]

CA1: Assignment X8 Questions


Question X8.5

(i) Explain why supervisory authorities require financial providers to maintain a specified level of solvency capital. [4]

(ii) Discuss the relationship between the strength of the supervisory provisions for

individual contracts and the level of solvency capital required. [2] [Total 6] Question X8.6

Outline the issues an actuary to a defined benefits pension scheme should take into account in setting the terms for the commutation of retirement pension benefits for cash. [9] Question X8.7

The only benefit provided by a pension benefits scheme is a retirement pension for life to the member. There is an option for the member to exchange part of their pension for a pension payable to their chosen dependant. The dependant’s pension will be paid from the death after retirement of the member, for the remainder of the life of the dependant. (i) Discuss the factors to consider in setting the option terms. Your answer should

address:

● general principles

● assumption setting

● selection

● product design factors. [10] (ii) Outline any measures you might recommend be applied to prevent anti-selection

on the exercise of the option. [4] [Total 14]



… in other words, there is a risk that small margins introduced in many assumptions could lead to a basis that is unintentionally too prudent. [½] Past practice should be considered, as there may be a need to be consistent with previous valuations. [½] There may be also be tax implications, eg a more prudent basis would defer the sponsor’s profit, and therefore defer its tax liabilities. [½] [Maximum 9] Solution X8.4

(i) Key accounting ratios Financial condition

● solvency ratio

● asset / liability ratio

● return on capital employed

● price / earnings ratio Profitability of business

● clams ratio (ie the ratio of claims to premiums)

● incurred expenses to premium income

● commission to premium income

● reinsurance premium outgo to reinsurance recoveries [½ each, maximum 3]

(ii) Interpreting the accounts Consideration should be given to the accounting rules and conventions that apply in the country concerned ... [½] ... these may well be unfamiliar to the domestic insurer and would make comparisons difficult. [½]



The basis used to value the liabilities should be considered ... [½] ... this is difficult to determine from the accounts and will depend on:

● the internal model / assumptions used

● the management’s risk appetite

● any actuarial judgement etc. [½ each for relevant examples, maximum 1]

The basis used to value the assets should be considered. [½] For example:

● how does it treat realised and unrealised capital gains / losses? [½]

● whether assets are valued at market value or by some other method – if assets are valued at market value they are likely to be quite volatile, so current market conditions should be considered. [½]

The accounts may be distorted by exceptional events, such as:

● large / catastrophic losses

● a redundancy exercise

● mergers / acquisitions

● exceptional expenditure, eg IT development etc. [½ each for relevant examples, maximum 1]

It may well be difficult to get a clear picture of the above factors due to the level of detail provided in the accounts. [½] The company is small, so the results may be quite volatile. [½] The position in the insurance cycle should be considered, since this can have a significant impact on profitability. [½] The accounts in isolation do not give a clear picture of the condition of an insurer. Trends over time are more important ... [½] ... however such trends can be difficult to analyse because changes in the reserving basis might mean that year-on-year results are not consistent. [½]



The accounts should be compared to relevant competitors if possible ... [½] ... for example, those:

● based in the country concerned and subject to the same accounting rules

● writing similar classes and mix of business

● using similar levels of reinsurance. [½ each for relevant examples, maximum 1]

[Maximum 6] Solution X8.5

(i) Reasons for maintaining solvency capital The solvency capital provides an additional level of protection to the customer over and above that provided by the individual provisions alone. [½] The objective is to reduce the likelihood of the financial provider becoming insolvent in reasonably foreseeable circumstances. [½] It should also help increase confidence in the industry and therefore help prevent systemic collapse. [½] If the provider is unable to meet the solvency capital requirements of the supervisory authority, this may trigger intervention by the authority. [½] This could lead to onerous requirements being placed on the insurer. [½] For example:

● more strenuous reporting requirements [½]

● requirement to submit a recovery plan to the supervisor [½]

● a review of management practices etc. [½] [Total 4] (ii) Relationship between provisions for individual contracts and solvency capital When considering the adequacy of the provisions that have been set up for individual contracts, it is important to do this in the context of the solvency capital requirements and vice versa. [1]

c CA1: Assignment X8 Solutions



ca1-pu-12

Documents

replacement pages

additional pages

examinations chapter

chapter summary

acted course notes

price course notes

uptodate course notes

core reading