st7 cmp upgrade 2014 - acted upgrade/st7-pu-14.pdf · st7: cmp upgrade 2013/14 page 3 the actuarial...

ST7: CMP Upgrade 2013/14

The Actuarial Education Company © IFE: 2014 Examinations

Subject ST7

CMP Upgrade 2013/14

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 2013 study material to make it suitable for study for the 2014 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 2014 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 2014 exams.


© IFE: 2014 Examinations The Actuarial Education Company

1 Changes to the Syllabus objectives and Core Reading

1.1 Syllabus objectives Syllabus objective (k)(iv) has been changed to: “(iv) Describe the Mack and bootstrapping approaches to reserving.”

1.2 Core Reading Chapter 3 Page 37 A new paragraph of Core Reading has been added, which discusses the use of telematics in motor business. We recommend that you remove pages 3738 from your Course Notes and use replacement pages 37, 38a, 38b and 38c provided below. Chapter 6 Page 20 A new discussion on the EU Gender Directive has been added.

We recommend that you remove pages 1920 from your Course Notes and use replacement pages 19, 20a, 20b and 20c provided below.

Chapter 8 Page 1 The first sentence of Core Reading now reads:

“Lloyd’s is a key player in the worldwide general (non-life) insurance and reinsurance market, with just under £25.5 billion of gross written premium in 2012.”



Page 4 The final sentence of Core Reading now reads:

“By the end of 2011 there were 57 managing agents, managing a total of 87

active syndicates and 5 RITC syndicates.”

Page 10 The second sentence of Core Reading in Section 3.2 now reads:

“In addition, Lloyd’s in aggregate must demonstrate overall solvency (that is, based on the aggregate of all members’ exposures or net liabilities) to the regulator (the Prudential Regulation Authority, PRA) by holding additional assets centrally (known as the central assets for solvency).”

Chapter 9 Page 8 A new list has been added after the first paragraph on page 8. This reads:

“Reserves booked will usually be greater than best estimate due to:

smoothing of results

difficulty in setting reserves, particularly reinsurance recoveries

requirements of regulatory bodies

peer pressure.”

Page 17 A new portion of Core Reading has been added, which discusses uncertainty arising from the treatment of large losses. We recommend that you remove pages 1516 from your Course Notes and use replacement pages 15, 16a, 16b and 16c provided below. Page 28 A new sentence of Core Reading has been added, at the end of the section on broker mergers. This reads: “This can be a particular issue for commercial risks where both insureds and

brokers are far bigger than the insurers.”



Chapter 10 Page 4 The start of the third paragraph now reads: “Industry-wide (or industry-source) data is collected and compiled by member

offices of particular organisations, for example, the ABI (Association of British Insurers) and Lloyd’s of London in the UK.” Page 7 A new use of data has been added to the list of bullet points: catastrophe modelling.

Page 10 Two new users of data has been added to the list of bullet points: risk management

catastrophe modelling.

Page 11 The second example now reads:

Example

In the UK, an insurer should have kept at least enough data to be able to compile the statutory returns to the PRA (Prudential Regulation Authority). There are similar requirements in some other countries.

Page 15 The last sentence above Section 3.3 now ends: “.... say, half the retention.”



Page 16 The last sentence of the example now reads:: “The former will provide claims details to be entered onto the insurer’s systems or onto bordereaux, while claims from the latter will be entered by the insurer’s own staff.” Page 17 A new sentence has been added before the first paragraph of ActEd text. This reads: “Both premiums and claims information may be bulk figures, and thus policy and claims details are hard to access.” The fifth paragraph now reads: “It may be time consuming for staff to enter such data into a computer system and so only major losses may be broken out from claims bordereaux, with the residual being entered as a bulk item. It is quicker to integrate data received electronically into the system.” Page 18 The last sentence in the paragraph discussing length of tail now reads: “This is particularly true of classes that are subject to significant delays in claim

notification or slow loss development.”

The last sentence above the examples now reads: “But the fact that the information will vary from risk to risk does not lend itself to

systematic data capture; often this is the case with London Market data.” Page 21

A new sentence has been added after Question 10.8. This reads:

“Clear links are needed between underwriting and claims databases eg via policy

reference numbers.”



Page 22

The last paragraph now reads:

“Written premiums are the premiums an insurer expects to receive over the duration of the policy. Written premiums may be before or after commission. The insurer should calculate the net written premiums by deducting any reinsurance premiums from the gross premiums.”

Page 26

The second list of bullets now includes a third point: the speed of notification.

Page 28 The third paragraph from the bottom of page 28 now reads: “In the London Market, policies are often coinsured by a number of different insurers. In these cases, the lead insurer will normally be responsible for handling the claim (although the second on the slip may also be involved) and will advise reserves to the following insurers. It is common for following insurers to use the reserve advised by the leader, although some insurers do alter the reserve for contentious claims where there are issues such as policy coverage.”

Page 29 The last sentence of the second paragraph now reads: “This is likely to occur some time after the original claim payments are made and the amounts are normally recorded as negative claim payments with a code to identify the type of receipt so that claim severities can be better assessed.”

Page 30 Another sentence has been added to the list of bullet points: for a claim made by a minor who can reclaim on attaining the age of 18.



Page 31 A new sentence has been added to the end of the second paragraph, which reads:

“Inwards claims are likely to have a catastrophe indicator and recoveries may be

proportional.”

A new discussion has been added to the end of the section on reinsurance recoveries. This reads: “The amount of the reinstatement premium would therefore be allocated to the claim(s) that had necessitated the use of the reinstatement cover. It is unlikely that one will allocate IBNR and paid claims to individual risks except for large London Market contracts. Indeed, it is very difficult to allocate IBNR to an individual claim because, by definition, we don’t yet know about it and therefore can’t know which claim to allocate it to.” Page 39 A new sentence has been added to the end of the section on check digits. This reads: “The policy number is often used as a link between different databases,

eg claims system and policy or client system.” Chapter 12 Page 9 A new sentence has been added to the final paragraph of Core Reading. This reads: “The level of regulatory capital required to support the business may also be

considered.” Page 12 The penultimate paragraph of Core Reading now ends: “Such superimposed inflation could be as a result of future step changes in average claim size arising from a change in the law or be reflective of the historical level of inflation seen in the claims.”



Chapter 13 Page 9 The first paragraph in the section on reporting years now reads: “Using this cohort, we group claims according to the year (or other period / cohort) in which they are reported to the insurer or reinsurer, irrespective of the original period of the claim event or when the insurance policy incepted.” Page 12 A new paragraph has been added before the section on prioritising work / materiality. This reads: “It should also be noted that the selected development period does not need to be the same length as the selected cohort period. For example, projections of underwriting year cohorts showing quarterly development periods are common.” Page 16 Two more examples have been added to the top of the page. These are: latent claims, such as claims arising from exposure to asbestos, pollution

and health hazards

other special or non-standard risks, such as Periodical Payment Orders in respect of private motor insurance.

Page 26 A fourth bullet point has been inserted into the list. This reads: A change in the period before non-active claims are reviewed – either to

chase for outstanding information or to close the claim as a nil claim. Therefore, the first sentence of Core Reading after Question 13.12 now reads: “The first four examples above might be expected to cause a one-off change in

the way that claims develop.”



A new sentence has been added to the bottom of page 26. This reads: “For some changes in claims handling procedures, which only affect the development of incurred claims, it may be appropriate to rely more heavily on paid development data for the projection.”

Page 27 The second paragraph under the section on claims reviews now reads: “However, if such reviews are infrequent, or if a large “one-off” review has been carried out, or if the company undertakes the reviews more frequently than it has in the past, it may be necessary to adjust the development pattern derived from the data.” Page 28 A paragraph has been added to the section on seasonality. This reads: “Seasonality can also impact the speed at which claims are processed – for example, fewer claims may be processed during December when there are a greater number of Bank Holidays.” Page 39 A new sentence has been added before Question 13.18. This reads: “In many cases it can be useful to undertake projections on both paid and incurred data, and to compare and understand the differences in order to gain helpful insights and select the most appropriate approach.”

Page 40 The first paragraph now ends: “...if conservative case reserves are set up at the outset or if case reserves are

held for claims which subsequently settle for nil.” Page 44 The last sentence on page 44 now reads: “We can also use curve fitting to smooth development patterns or to select a tail

factor to allow for development beyond the oldest development period.”



Page 48 A new sentence has been added under the first paragraph of Section 3.4. This reads: “As noted above, it is also a simple method to apply and is especially useful

when data is scanty, unreliable or missing altogether.” Page 59 The paragraph at the end of the bullet points now reads:

“We note that the definition of claim numbers affects the average claim sizes. For example, whether nil claims are included or excluded will affect the selected average claim sizes (all other things being equal). It is of utmost importance to ensure that the claim frequency and claim severity are consistent.” Page 61 A new bullet point has been added to the list of strengths. This reads: Enables more accurate adjustments to be made (where these only affect

the frequency or the severity of claims) which would not be possible with other (aggregate) methods.

Page 69 The second paragraph of Core Reading now reads: “In determining the need for an additional reserve the extent to which different categories of business can be aggregated should be considered, such that anticipated future profits from some categories of business may offset potential inadequate premiums in other categories.”

Chapter 14 Page 2 Two new points have been added to the first list of bullets. These are: the emergence of new types of claim

changes in the way claims are settled – for example, if more claims are settled in the form of Periodical Payment Orders (rather than as lump sums).



Page 4 The last sentence of the first paragraph now reads: “We are interested in the uncertainty of reserves, including its impact on the

capital backing the insurance liabilities and its sufficiency.”

A new bullet point has been added to the bottom of page 4. This reads: Inform the management / Board of the insurance company to assist with

ongoing decision making, for example in what areas to expand or contract the volume of business being written.

Page 30 A new bullet point has been added to the list. This reads: Stress and scenario tests around the most significant assumptions and

key areas of uncertainty.

Chapter 15 Page 14 Another example has been added. This reads: business written on a risk attaching basis compared with a claims made

basis. This is because late reported claims will fall into a subsequent policy year. This was discussed in Chapter 13.

Page 21 22 New Core Reading has been added to Section 5.2 and a new section has been added discussing the reserving cycle. We recommend that you remove pages 2122 from your Course Notes and use replacement pages 21, 22a, 22b and 22c provided below. Page 25 This page has been deleted.



Chapter 17 Page 3 The final paragraph now reads:

“Medium-dated fixed-interest stocks, index-linked stock where available and, to a very limited extent, equities and real estate are the likely choices of assets to support longer-tail insurance classes.” Page 4 The second bullet point now reads: earnings inflation, medical inflation and judicial inflation will affect bodily

injury claims for liability business. The first sentence of the last paragraph has been deleted. Page 6 In the third paragraph of Core Reading, the first sentence now reads: “The way in which an insurer chooses to invest the assets supporting the free reserves will be influenced by the size of the free reserves, and by permissible holdings based on the regulatory regime to which the insurer is subject.”

Page 10 The last sentence of Core Reading has been deleted. Page 22 The second bullet point now reads: regulatory constraints, for example, those imposed by Lloyd’s, the

Prudential Regulation Authority (PRA) and the Financial Conduct Authority (FCA).

Page 29 The first sentence now reads:



“The insurer could then attempt to reduce this probability to an acceptable level. However, it is highly dependent on the chosen probability distribution functions, and other assumptions such as those around dependencies between risk types, products and so on.”

Page 36 A new section on reverse stress and scenario testing has been added. We recommend that you insert new pages 36b and 36c below into your Course Notes. Chapter 21 Page 12 The third and last paragraphs of Core Reading now refer to “the PRA” instead of “the FSA”. Chapter 23 Page 7 The penultimate bullet now reads: territory – USA, Western Europe, Asia-Pacific, South/Central America,

Africa, MENA (Middle East and North Africa) and so on Chapter 24 Pages 2 and 4 New Core Reading has been added to pages 2 and 4. We recommend that you remove pages 1 4 from your Course Notes and use replacement pages 1 4c below. Page 8 A new bullet point has been added to the list on page 8. This reads:

reinsurance offset / recoveries.



Page 9 The penultimate paragraph now reads:

“We may deem the unearned premiums less deferred acquisition costs carried forward to be insufficient to cover the cost of the claims and expenses that will be incurred in the period of unexpired risk. That is, if we wrote a potentially lossmaking contract (onerous contract) in the previous period, then not only will we need to recognise any premium to be earned in a future year, but we will also recognise the reserve that we need to put aside to cover the risk that we undertook: We should therefore establish an additional reserve for unexpired risk. The excess of that reserve over any corresponding reserve at the end of the previous year will form part of the outgo in the latest accounting year. ”

Page 17 The Core Reading on IFRS and UK GAAP has been updated. We recommend that you remove pages 17 18 from your Course Notes and use replacement pages 17 18c below. Chapter 25 Page 2 An additional paragraph has been added to the explanation of the consistency accounting concept. This reads: “Since actuaries are crucial in the reserving process it is important to understand that variations in the level of prudence applied year on year lead to releases of profit (potential for profit manipulation) which is against the accounting principles. Therefore one of the most important things in the reserving cycle is consistency.” Page 3 Further explanation of IFRS Phase II has been added. We recommend that you remove pages 3 4 from your Course Notes and use replacement pages 3 4c below. Page 8 Further Core Reading has been added. We recommend that you remove pages 7 8 from your Course Notes and use replacement pages 7 8 below.



Chapter 26 Page 9 The deadlines on this page have been amended. We recommend that you remove pages 9 10 from your Course Notes and use replacement pages 9 10 below. Glossary Page 1 The final phrase has been deleted. This was: “– an example being the Claims Reserving Manual published by the Faculty and Institute of Actuaries.” Page 7 The definition of a bordereau has been updated to read: “A detailed list of premiums, claims and other important statistics provided by ceding insurers to reinsurers (or by coverholders to insurers in direct insurance), so that payments due under a reinsurance treaty (or delegated authority schemes in direct insurance) can be calculated. ” Page 10 The definition of a claim cohort has been updated to read: “A group of claims with a common period of origin. The period is usually a month, a quarter or a year. The origin varies but is usually defined by the incident date of a claim, the date of reporting of a claim, the date of payment of a claim, or the date when the period of cover to which a claim attaches commenced.” Page 14 The definition of deferred acquisition costs has been updated. The first sentence now to reads: “Acquisition costs relating to unexpired periods of contracts in force at the balance sheet date.”



Page 18 In the definition of experience rating, the end of the first paragraph now reads: “...a “collar” or “corridor”.” Page 19 The definitions of Financial Services and Markets Act 2000 (FSMA)* and Financial Services Authority (FSA)* have been deleted.

Page 20 A new definition of fronting has been included. This reads: “Fronting Fronting occurs when an insurer, acting as a mere conduit, underwrites a risk and cedes all (or nearly all) of the risk to another insurer which is technically acting as a reinsurer. The ceding or “fronting” insurer will typically receive a fee for its involvement to cover its expenses and profit. In insurance the term “fronting” may also be used to describe the process whereby an individual effects a policy for him/herself but tries to save money by putting the policy in someone else’s name.” Page 39 In the definition of required solvency margin, “FSA” has been changed to “PRA”. Page 46 The definition of Value at Risk has been changed to: “Value at Risk (VaR)

In financial mathematics and financial risk management, Value at Risk (VaR) is a widely used measure of the risk of loss. For a given probability and time horizon, VaR is defined as a threshold value such that the probability that the loss on the portfolio over the given time horizon exceeds this value is the given probability level.”



Pages 48 52 The following items have been added to the list of abbreviations:

ATAFs Age to age factors

ATUFs Age to ultimate factors

BAU Business as usual

FCA Financial Conduct Authority

ORSA Own Risk and Solvency Assessment

PRA Prudential Regulation Authority

SCR Solvency Capital Requirement

TAS Technical Actuarial Standard The following items have been deleted from the list of abbreviations: FSA Financial Services Authority

GRIP General insurance premium Rating Issues working Party

GRIT General insurance Reserving Issues Taskforce



2 Changes to the ActEd Course Notes

Chapter 1 Page 27 The penultimate sentence in Question 1.15 should read: “A total of £5,500 was paid in claim settlements in 2012.” Chapter 2 Page 19 The last sentence now reads: For example, the European Court of Justice recently ruled that a person’s sex can no longer be used to calculate insurance premiums. Chapter 3 Page 37 A new paragraph of ActEd text has been added, to follow the new Core Reading on the use of telematics in motor business. As stated above, we recommend that you remove pages 3738 from your Course Notes and use replacement pages 37, 38a, 38b and 38c provided below. Chapter 6 Page 19 A new explanation has been added to the penultimate bullet of page 19. This reads: “For example, under the EU Gender Directive, European insurers are no longer allowed to use gender as a rating factor. (This is discussed further below.)"



Pages 20-21 A new ActEd discussion has been added to supplement the new Core Reading on the EU Gender Directive.

As stated above, we recommend that you remove pages 1920 from your Course Notes and use replacement pages 19, 20a, 20b and 20c provided below. Chapter 9 Page 3 A new bullet has been added at the top of the page:

Portfolio movements: Unexpected changes in the volume and mix of business can cause an insurer uncertainty.

Page 17 A new ActEd discussion has been added to supplement the new Core Reading on the uncertainty arising from the treatment of large losses. As stated above, we recommend that you remove pages 1516 from your Course Notes and use replacement pages 15, 16a, 16b and 16c provided below. Chapter 10 Page 11 The final paragraph has been updated to read: “The PRA is one of the successors to the FSA (Financial Services Authority), with effect from 1 April 2013. Amongst other things, it is responsible for the supervision and regulation of insurance companies in the UK.” Page 31 A new discussion has been added to the end of the section on reinsurance recoveries. This reads: “The amount of the reinstatement premium would therefore be allocated to the claim(s) that had necessitated the use of the reinstatement cover.



It is unlikely that one will allocate IBNR and paid claims to individual risks except for large London Market contracts. Indeed, it is very difficult to allocate IBNR to an individual claim because, by definition, we don’t yet know about it and therefore can’t know which claim to allocate it to.” Page 51 The final paragraph in the section on uses and users of data now reads: “The full development team for a computer system should include senior management, accountants, underwriters, claims managers, marketing, investment, computing staff, risk management staff, catastrophe modellers and reinsurers, as well as actuaries.” Page 56 Two more points have been added to Solution 10.5. These are: “Risk management: monitoring the size and nature of risks written, identifying

aggregations of risk, implementing risk controls Catastrophe modelling: assessing and quantifying catastrophe risks.” Chapter 13 Page 89

The second table in Solution 13.24 part (iii) should read:

Ratios Ppn claims paid to date Ppn claims O/S Year O/S claims

0.7255 0.5362 0.4638 2012 22,919

0.8017 0.7390 0.2610 2011 18,038

0.9232 0.9219 0.0781 2010 5,041

0.9986 0.9986 0.0014 2009 95

Outstanding Claims Reserve 46,093



Chapter 14 Page 36 A new point has been added to the last list of bullets. This reads: stress / scenario tests Chapter 15 Page 14 An ActEd explanation has been added to the new Core Reading bullet point. This reads: business written on a risk attaching basis compared with a claims made

basis. This is because late reported claims will fall into a subsequent policy year. This was discussed in Chapter 13.

Page 21 22 ActEd text has been added to help explain the new Core Reading. As stated above, we recommend that you remove pages 2122 from your Course Notes and use replacement pages 21, 22a, 22b and 22c provided below. Page 28 The last bullet point on the page has been deleted. Page 31 In Solution 15.8, the development factor for 2008, development period 1 has been corrected to 1.284 instead of 1.294. Chapter 21 Page 12 A new sentence of ActEd text has been added after the third paragraph of Core Reading. This reads: “The Board for Actuarial Standards (BAS) has now been replaced by Financial Reporting Council (FRC) Board.”



Chapter 24 Pages 17 Additional ActEd text has been written to supplement the new Core Reading on IFRS and UK GAAP. As stated above, we recommend that you remove pages 17 18 from your Course Notes and use replacement pages 17 18c below.



3 Changes to the Q&A Bank Part 2 Question and Solution 2.19 has been deleted. Part 3 The end of Question 3.10 part (iv) has been corrected to read: “... calculate a revised estimate of the ultimate gross claim payments for the 2012 accident year.” Part 4 In Solution 4.17 part (ii), the third bullet point now refers to “the PRA” instead of “the FSA”. In Solution 4.22 part (ii), the last bullet point now refers to “the PRA” instead of “the FSA”. Part 6 Question 6.18 part (ii) has been corrected. We recommend that you remove pages 7 8 from this Q&A bank and use replacement pages 7 8 provided below. In Solution 6.11 part (iii), the last two bullet points have been updated to say 2014 and 2016 respectively. In Solution 6.18 part (ii):

for the third half mark, the mean of the loss ratio distribution truncated at 100% is 86.5

for the fourth half mark, the mean of the loss ratio distribution truncated at 80% is 85.1.



4 Changes to the X Assignments

A comment has been added to each solution detailing what part of the course it covers. Assignment X1 Questions X1.8 and X.19

Part (iii) of Question X1.8 has been deleted and a new Question X1.9 has been written. We recommend that you remove pages 3 4 from your X1 Assignment and use replacement pages 3 4 provided below. Solutions X1.8 and X1.9

Part (iii) of Solution X1.8 has been deleted and a new Solution X1.9 has been written. We recommend that you remove page 15 16 from your X1 Assignment and use replacement pages 15 16 provided below. Assignment X2 Question X2.3 This has been replaced with a new question, which reads: “A rich friend of yours has just become a Lloyd’s Name. He has joined a syndicate that writes only marine insurance. List sources of risk and uncertainty which will affect the return that he makes from his capital outlay. [6]” Solution X2.3 This has been replaced with a new solution. We recommend that you remove page 3 4 from your X2 Assignment and use replacement pages 3 4 provided below. Assignment X3 Solution X3.5 In part (ii), one of the headings in table has been corrected. It now says “Percentage developed” instead of “Grossing up factor”.



Assignment X4 Question X4.4 This question has been replaced. It now reads: “Give reasons for correlations between different lines of business and describe how allowance can be made for correlations within a stochastic model. [4]” Solution X4.4 This has been replaced with a new solution. We recommend that you remove page 3 4 from your X Assignment and use replacement pages 3 4c provided below. Assignment X6 Question X6.2 This question has been rewritten. We recommend that you remove page 1 2 from your X Assignment and use replacement pages 1 2 provided below. Solution X6.2 This has been replaced with a new solution. We recommend that you remove page 1 4 from your X Assignment and use replacement pages 1 4c provided below.



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 ST7:

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

Flashcards

Mock Exam A and the Additional Mock Pack

Revision Booklets For further details on ActEd’s study materials, please refer to the 2014 Student Brochure, which is available from the ActEd website at www.ActEd.co.uk.

5.2 Tutorials We offer the following tutorials in Subject ST7:

a set of Regular Tutorials (lasting three full days)

a Block Tutorial (lasting three full days) 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 2014 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.


All study material produced by ActEd is copyright and is sold for the exclusive use of the purchaser. The copyright is owned

by Institute and Faculty Education Limited, a subsidiary of the Institute and Faculty of Actuaries.

Unless prior authority is granted by ActEd, you may not hire out, lend, give out, sell, store or transmit electronically or

photocopy any part of the study material.

You must take care of your study material to ensure that it is not used or copied by anybody else.

Legal action will be taken if these terms are infringed. In addition, we may seek to take disciplinary action through the

profession or through your employer.

These conditions remain in force after you have finished using the course.

ST7-03: Insurance products – types Page 37


Motor property Motor insurance is a good example of a class of insurance where possible risk factors can be identified, but it is generally difficult to regard them as meeting the criteria needed to use them as rating factors. For example the following are all risk factors:

● the number of miles driven

● the density of the traffic where the car is driven

● the ability of the driver

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

● the ease with which the vehicle can be damaged and the cost of repairing it

● the theft risk

● weight of the vehicle

● fire risk. These are generally not all measurable or quantifiable statistics. However, at the time of writing, there is in many countries a gradual increase in the use of telematics, whereby the driving behaviour and other factors can be monitored through the use of a black box. This makes some of the above factors measurable, and the results can be used to help price the policy. The term “black box” here doesn’t refer to a box that is black (although it might be!). Rather, it is a device or system that is placed in a motor vehicle to monitor the way in which the vehicle is driven. It can measure speed, acceleration, braking, etc as well as monitoring exactly when the vehicle is driven. It’s called a black box because we will generally know very little about its inner workings. Therefore, the insurer cannot depend on information on these risks received from the policyholder as there is considerable scope for the policyholder to stretch the truth in his or her favour or be too subjective about his or her own skills.

Question 3.17

Name some other risk factors for motor insurance that can also be used as rating factors.

a ST7-03: Insurance products – types


Question 3.18

State whether the following risk factors are likely to affect the frequency of claims, the size of claims, or both:

(i) where the car is driven

(ii) how expensive the car is to replace / repair

(iii) how fast the car is driven.

Type of cover is the most important rating factor, as varying the type of cover can exclude an entire class of claims.

For example, third party cover will not include any claims for accidental damage to the insured’s own vehicle.

Policy excess is also an important rating factor as it too will affect claim sizes. Many small claims may be eliminated altogether leading to a reduction in claim frequency and expense savings. An excess may be compulsory (for example for a young driver) or optional to secure a reduction in the premium. Typically insurers will offer proposers a choice of excess levels. Other rating factors are proxies for those risk factors for which direct information is unreliable. These include:

● the use to which the vehicle is put (eg for business use)

● the age of the vehicle

● the occupation of the policyholder and other drivers

● whether there are additional drivers of the vehicle as well as the policyholder

● sex of main driver

● age of policyholder and other drivers

● whether or not driving is restricted to certain named drivers

● make and model of vehicle

● the extent of any modification to the engine or body

● location of policyholder (eg postal code)

● where the vehicle is kept overnight: on the road / on a driveway / in a garage etc

● whether or not the driver has any driving convictions

● past experience.

ST7-03: Insurance products – types Page 38b


Question 3.19

The age of the policyholder and the address of the policyholder are proxies for which risk factors?

c ST7-03: Insurance products – types


This page has been left blank so that you can slot the replacement pages

into your Course Notes.

ST7-06: General insurance markets Page 19


3 Regulatory and fiscal regimes

3.1 The need for supervision

Why should insurance business suffer more legislation than, say, umbrella manufacturers? One of the reasons is that there is more scope for the purchaser to lose out financially. When you buy an umbrella, you have a look at it, and if you like it, you pay the price. However, with insurance, you pay the price at the start of the contract and you have to trust the insurer to pay valid claims as and when they arise in the future. The uncertainty underlying insurance business means that it is not just a question of trusting the honesty of the insurer. The insurer may be very well meaning, but if the insurer’s business is not soundly managed, you may find that the insurer has collapsed by the time you need to make a claim. In many countries, therefore, there are specific rules and regulations that apply to general insurers. Different countries adopt different approaches to the regulation of insurers’ operations.

3.2 Effect of the regulatory regime

The following regulatory restrictions on the actions of a general insurer may be encountered in one or more countries of the world:

● Restrictions on the type of business that a general insurer can write or classes for which the insurer is authorised. An authority could prevent an insurer from writing volatile classes of business or classes where it had little expertise.

● Limits or controls on the premium rates that can be charged.

For example, the authorities in some US states, eg Massachusetts, set the personal motor premium rates that must be charged. Some states require that rates are filed (sent to the relevant state department for approval) prior to an insurer using them. An authority could also set a maximum or minimum premium or restrict the way in which the premiums are calculated. For example an authority could set a maximum allowance for expenses defined as a percentage of the gross premium.

a ST7-06: General insurance markets


● A requirement that the general insurer maintains a minimum level of solvency, measured in some prescribed manner, ie a minimum level of free assets. This might, for example, be calculated as a proportion of premiums written.

● Restrictions on the types of assets or the amount of a particular asset that a general insurer can take into account for the purposes of demonstrating solvency. This might be with the possible aim of avoiding risky investments or increasing diversification.

● A requirement to use prescribed bases for calculating premiums or for valuing the general insurer’s assets and /or liabilities when demonstrating solvency.

● Restrictions on individuals holding key roles in companies.

● Licensing of agents to sell insurance and requirements on the methods of sale and disclosure of commission / broking terms.

● A requirement to pay levies to consumer protection bodies.

● Legislation to protect policyholders if a general insurer fails.

Question 6.9

Suggest possible legislation that could be used to protect policyholders if a general insurer fails.

EU Gender Directive The EU Gender Directive was passed in 2004, being aimed at “implementing the principle of equal treatment between men and women in the access to and supply of goods and services”. In its original form, the EU Gender Directive included an opt-out in respect of financial and insurance products provided that certain conditions were met. In March 2011, the European Court of Justice gave its ruling on the legality of the insurance opt-out provision, concluding that it is not valid and should therefore be removed with effect from 21 December 2012. From that point, insurance companies have no longer been able to use gender as a rating factor. However, insurance companies are careful to avoid the use of proxy rating factors (ie highly correlated to gender) that might be deemed to be indirect discrimination and thus also not permitted.

ST7-06: General insurance markets Page 20b


Clearly, the inability to differentiate between gender when setting premium rates is having significant implications for insurance pricing, particularly for motor insurance where there are material observed differences in claims experience according to gender at certain ages. Each insurer is likely to set premium rates based on the expected mix of business by gender but there is the risk that the mix of male / female policyholders turns out not to be as expected. The introduction of this legislation has therefore increased the uncertainty of insurers’ claims experience and profitability. It is not yet clear how premium rates or underwriting practices have changed as a result of the ruling. However it is likely that premiums have not simply “met in the middle”, but that there have been additional contingency loadings for the risk of business mix by gender not being as expected within the unisex pricing. In other words, this legislation has also led to increased uncertainty in premium rates, at least in the short term, and hence higher risk margins being charged by insurers. Other possible regulations Other regulations that could be imposed on general insurers include:

● requirement to provide detailed reports and accounts at prescribed intervals

● requirement to purchase reinsurance

● requirement to hold a claims equalisation reserve

● limits on contract terms

● advertising restrictions

● prescription to hold certain assets.

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ST7-09: Modelling uncertainty Page 15


3.2 Incorrect dependencies

A number of the variables in the model will be correlated with one another; for example, interest rates and claims inflation.

Question 9.10

How might interest rates and claims inflation be correlated?

It is important that the dependencies are programmed correctly. The correlations can be regarded as additional parameters, and it is essential that they are not overlooked.

3.3 Change in case estimate reserving philosophy

Reserving philosophy within a company will change from time to time.

Example If claims handlers have under-reserved a case in the recent past, they may be inclined to overestimate future claims to compensate.

There may also be changes in reserving philosophy following a change in senior personnel. This could involve a change in reserving methods, or a change in the basis used for the reserve estimates (within an acceptable range). If changes in reserving philosophy are known, it may be possible to make adjustments.

3.4 Planned or unplanned changes in mix

If the mix of business changes significantly, either as a result of the company pursuing a particular strategy or through unknown causes, the development pattern is likely to change, and in an unpredictable way. This increases the difficulty of selecting appropriate parameters with which to model the business. Changes in business mix were also discussed in Section 1.2.

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3.5 Large and exceptional claims

Large claims Large claims can be expected to have different frequency and severity distributions to attritional and catastrophe claims. They are also likely to have different development patterns. There may also be differences in development pattern based upon the type of large claim.

Example A large windstorm claim may develop at a different rate to a large flood claim, although both types of claim may be experienced in a property book.

It is normal practice to remove large claims from the development and project these separately. Uncertainty may also arise in how a large claim is defined. They could be defined as claims over a particular threshold limit (possibly with a different threshold for different perils, often set to achieve sufficient data and with an eye on the reinsurance programme), or large claims may be a subjective management decision. If the threshold for what constitutes a large claim is too low, then a large quantity of data will be excluded from the attritional claims triangulation, and this will result in the triangulation data (and the reserve estimates) being less credible. However, if the threshold is set too high, then more large claims will be included in the attritional triangulation data, and this will increase the volatility of the projection. In practice, the definition of a large claim might be set at the retention limit for the non-proportional reinsurance programme. This would make a projection of net of reinsurance claims much easier. (Reinsurance reserving will be discussed in Chapter 23.) If the threshold limit method is chosen, there is the additional uncertainty as to whether this increases over time, and at what rate. Effectively the threshold would decrease going backwards through cohorts. An insurer is likely to increase the definition of what constitutes a large claim periodically, in order to allow for claims inflation and maintain the real value of the threshold. Hence prior origin years might well have a lower threshold than the current origin year. The rate of inflation to apply to the threshold limit is likely to be uncertain and will often differ from the rate at which attritional claims inflate.

ST7-09: Modelling uncertainty Page 16b


On some occasions, there may be an absence of large reported claims, and the reserving actuary may wish to add a loading to reflect this fact. This will give rise to additional uncertainty. Catastrophes Catastrophic losses can take the form of one immense loss, such as an oil-rig explosion. Alternatively, there may be many smaller insured losses, all stemming from a common, identifiable event such as a hurricane. Catastrophes are typically hard to predict, so are hard to reserve for. One way to reduce the impact of catastrophic losses is to write business in a wide range of geographical locations and across many classes. Catastrophe reinsurance will also help (more of this later in the course). Latent claims Catastrophic claims can also result from sources that were unknown, or for which a legal liability was not expected, at the time of writing the business. The cost of such claims cannot be calculated with any accuracy for the purpose of setting reserves.

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ST7-15: Assessment of reserving results Page 21


The speed at which the bottom of the cycle is reached and rates begin to harden is often increased by external factors such as large catastrophe claims, which can reduce profitability and increase the pressure on rates to harden. Rates then continue to increase (harden) until we are back in a hard market and the process starts all over again. The length of the underwriting cycle varies by class of business and territory. For example, in some UK personal lines classes, it is around seven years. It will be dependent on, for example:

● macro-economic effects, eg people pay less for insurance and claim more when economic conditions are poor

● investment conditions (if it is expected that good returns can be made on invested premiums then the insurer may be prepared to offer softer premium rates)

● major industry losses, eg natural disasters or terrorism.

5.2 Impact of the underwriting cycle on the assessment of reserves

The underwriting cycle can have an influence on claims development. For example in a hard market, individuals who perceive themselves as low-risk may choose to self-insure rather than pay high premiums, resulting in anti-selection against the insurer. When assessing the reasonableness of the results of a reserving exercise, we should consider whether we have allowed appropriately for the underwriting cycle. One way to allow for the underwriting cycle in reserving exercises is to use a rate index when deriving the initial expected loss ratios for use in credibility-type methods. We should be careful, however, when selecting appropriate rate indices because:

● Rate indices are typically only available for renewal business and therefore may not adequately allow for any differences between new and renewed business.

● Rate indices can sometimes be constructed largely based on highly subjective information (such as the underwriters’ views rather than hard data).

a ST7-15: Assessment of reserving results


● In addition to changes in the actual premium charged, there may also be changes over time in the terms and conditions or limits and deductibles of the cover provided, which will also impact on the profitability of the business being written, and which are not necessarily reflected in the rate indices. Changes in these elements of the cover tend to vary in relation to different phases of the underwriting cycle: as the market hardens, insurers remove or reduce the more optional – and often expensive – parts of the cover, and these then gradually come back in again as the market softens. In an ideal world any rate index should attempt to take account of these changes, which are inevitably more difficult to quantify than pure changes in the premium charged.

Question 15.11

What impact will the following have on claims development patterns?

(i) looser terms and conditions

(ii) lower deductible.

ST7-15: Assessment of reserving results Page 22b


6 The reserving cycle

Recent studies have also suggested the existence of a “reserving cycle” which is highly correlated with the underwriting cycle. This appears to show that in a soft market, incurred claims development patterns are slower to develop (or longer-tailed) than in a hard market so that an unadjusted projection can underestimate ultimate claims in a soft market (and, equivalently, overestimate them in a hard market, when insurers can afford it). Potential reasons for this phenomenon include:

● the effect of weakened terms and conditions

● an increasing tendency to dispute claims

● a possibly less conservative approach to case reserving when results are worse

The evidence of a reserving cycle is more noticeable for business which is already thought to be longtailed. The initial expected loss ratio can be chosen to take account of changes in the reserving cycle as well as changes in the underwriting cycle. This over-estimation or under-estimation of reserves is a decision to be made by the Board. It should not impact the actuary’s best estimate, although he or she may wish to indicate a range of “best estimates” within which he or she believes that the Board’s decision should lie.

The general insurer is likely to wish to flatten the reserving cycle:

● so that reserves are more accurate. This reduces the likelihood of insufficient reserves being set up in past years, which will have a detrimental impact on the ongoing business

● so that the profitability of the business can be more readily understood. Appropriate decisions can then be made as to whether to continue, contract or expand a class.

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ST7-17: Investment principles and asset liability matching Page 36b


13.7 Reverse stress and scenario testing

A complementary case of stress and scenario testing is reverse stress testing. Some regulatory authorities require firms to carry out reverse stress testing, which is an assessment of scenarios and circumstances that would render its business model unviable. Reverse stress testing differs from general stress and scenario testing in that the starting point is the assumed outcome of business failure, thus the exercise being the identification of circumstances where this might occur, whilst the latter looks at the resulting outcomes arising from specified changes in circumstances. In other words, a reverse stress and scenario test identifies the circumstances / model assumptions required for the business to fail. This is in contrast to the more common use of a stress or scenario test which analyses the effect on the business of a given set of circumstances / assumptions.

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ST7-24: Accounting methods Page 1


Chapter 24

Accounting methods

Syllabus objectives (u)(i) Describe the methods and principles of accounting for general insurance

business and interpret the accounts of a general insurer. (ii) Describe the changes to accounting methods expected under IFRS.

0 Introduction There are two distinct methods used by general insurers to present their accounts:

● annual (or accident year) accounts, which consider all income earned and outgo incurred in a year and permit the release of profits at the end of that year

● funded (or underwriting year) accounts, which consider the business written in each year and do not permit the release of profits until the end of a subsequent year (usually the third year).

Section 1 gives a broad overview of the two methods, which are then discussed in detail in Sections 2 and 3. In Section 4 we discuss whether the accounts of a general insurance company reflect the true underlying profitability of the company. Section 5 goes on to explain how to construct simple accounts. This chapter contains a lot of additional explanation and a number of questions, to help illustrate the Core Reading and explain how these principles work in practice.

ST7-24: Accounting methods


1 Methods of accounting

1.1 Annual accounting

Annual accounting is the basis of accounting for general insurance business in the UK. Annual accounts are usually used for most forms of direct insurance (eg motor, household, employers’ liability, commercial property). Under annual accounting, we consider all income earned and outgo incurred in a year and can release profits at the end of the year. That is, income is recognised as earned - and the consequence is that profit or loss might arise from the business earned on that year. We carry forward unearned income into the next accounting period. The premium element of this is called unearned premium and unearned premium reserves and unexpired risk reserves are created. For example, if an annual policy is written on 1 September 2013, then for the 2013 calendar year, the earned premium will be one-third of the premium (assuming uniform risk over the policy year) and the other two-thirds of the premium will be carried forward into the 2014 calendar year. We also refer to this approach as “deferral and matching” because we defer profit release until the accounting period when the contracts are exposed to the risk of insured events. Profit is crystallised in the year the premium is earned the basis of all this is the accrual principle. This is not a cash basis (where, if you have a two-year policy, you earn half the premium in the first year and half in the next). Rather, the income recognition is matched to the risk taken in each period. Out of this flows the profit or loss made on the business. Annual accounts have traditionally been referred to as one-year accounts. You may also see them referred to as accident year accounts. The term accident year refers to a grouping of claims according to the year in which the loss event actually occurred, irrespective of when they are reported or paid, and the year in which cover commenced.



1.2 Funded (three-year) accounting

An alternative accounting approach, known as funded accounting or three-year accounting, was previously used by Lloyd’s of London and London Market companies operating in the Lloyd’s market. Funded (or three-year) accounts were introduced in Chapter 8. They are typically used for Lloyd’s, reinsurance and marine and aviation business. Under funded accounting, we considered the business written in each year and could not release profits until the end of three years. Lloyd’s of London now also uses an annual accounting basis, but the legacy of funded accounting remains in internal financial management as the underwriting year accounting approach is consistent with the way Lloyd’s syndicates manage capital.

Funded accounting is used in Lloyd’s when we calculate the reinsurance to close (RITC) and release profits to the Lloyd’s Names. It is also used by companies when we calculate the emerging profit and when we calculate underwriting and reserve risk, which may be reduced to reflect investment income that will be earned on assets held against reserves and on premiums received in relation to the current and prior underwriting years. Funded accounts are also referred to as underwriting year accounts. The term underwriting year refers to a grouping of claims according to the year in which cover commenced, irrespective of when the loss event occurred, and when the claims are reported or paid.

1.3 Reserving models

We typically associate accident year reserving models (based on accident year cohorts) with annual accounting, and we associate underwriting year reserving models (based on underwriting year cohorts) with funded accounting. However, many Lloyd’s syndicates and London Market companies continue to use underwriting year approaches, but then apply an adjustment to determine reserves on an annual accounting basis. The process of converting underwriting year results to accident year results is discussed further in Section 0.

a ST7-24: Accounting methods


2 Annual accounting

2.1 Introduction

In the annual accounting model for insurance contracts, we need to consider the following:

● Income – earned premiums, reinsurance recoveries received or accrued when the relevant claim has been recognised / paid, investment income, and changes in premium reserves / risk reserves / reinsurance reserves,

● Outgo – claims, claims handling expenses and other expenses paid and changes in claims outstanding (including IBNR) in the accounting period, reinsurance premiums, commissions, profit commissions, underwriting charges / taxes

● Assets – deferred acquisition costs, reinsurers’ share of unearned premium reserves, reinsurers’ share of claims outstanding

When policies are written the insurer pays commission and other initial expenses. At the accounting date those acquisition costs have been paid out but not wholly incurred for any policy that is unexpired at the time, just as part of the premium received has not yet been earned. (You could think of them as “unincurred expenses”, but the name “DAC” is universally used.) DAC is usually a significant asset in the insurer’s accounts. It is like a negative reserve. Decreasing DAC reduces the insurer’s profit, just as increasing reserves does.

● Liabilities – unearned premium reserve, additional unexpired risk reserve, claims outstanding

● Debtor and creditor balances reflecting outstanding payments due to or from policyholders, brokers and reinsurers.

Alternatively one can consider the building blocks as the premium (involves income) and the risk assumed (reflected in a liability) the model is based on the insurer being able to price the risk sufficiently well so that after paying the claims / paying the admin and getting the return on the investment of the money paid in premium, they will be able to make some profit. The precise layout of the published accounts will vary depending on the accounting rules in place.

ST7-24: Accounting methods Page 4b


2.2 The technical account

The technical account (or revenue account) shows the basic trading profit from writing insurance business for a given period. Note that strictly speaking, this terminology is only needed for Subject SA3 (it has an asterisk in the Glossary). To develop a clear understanding of the intricacies of a general insurer’s accounts, it is useful to start with the most basic model of how profits are made up. In its most basic form, profit for a given year can be expressed as:

profit = money in – money out – increase in reserves

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There are a few other differences between UK GAAP and IFRS mainly because, for instance, IFRS 4 permits a range of accounting policies from previous regimes. Hence there is currently some divergence across the board from IFRS reporters. For instance:

● Under UK GAAP, discounting is only permitted under very limited circumstances for general insurers (ABI SORP requires a run-off period of more than four years on average for the classes to be discounted).

● The definition of acquisition costs to be discounted is also prescribed in the ABI SORP, but in IFRS you could have a different definition if the previous reporting regime was different.

ABI SORP is the Statement Of Recommended Practice issued by the Association of British Insurers.

● Under UK GAAP the definition of insurance contracts is the same as

under IFRS, but the disclosure requirements (information in addition to the amounts in the financial statements) are not as onerous for general insurers.

The IFRS Phase II project on insurance contracts is in the process of developing a full measurement basis. Measurement / presentation and disclosure will be new and different under Phase II. The proposals are for a prospective measurement model comprising three components:

● probability weighted estimate of future cash flows

● discounted for the time value of money

● a risk margin. This is discussed further in Chapter 25, Interpreting accounts. This represents a fundamental change from the annual accounting model. The International Accounting Standards Board (IASB) is liaising with the industry, supervisors and national financial reporting authorities as it develops these proposals. The timetable for implementation is subject to change, although details of the current timetable can be found on the IASB’s website. Solvency II is a revised risk based approach to determining capital requirements across the European Economic Area. Solvency II is discussed in Chapter 26, Regulation and also covered in Subject CA1 and Subject SA3.

a ST7-24: Accounting methods


The IFRS Phase II proposals are broadly in line with the proposals for measuring insurance liabilities for Solvency II, although at a detailed level there are significant differences. The detailed IFRS proposals are beyond the scope of this course and will be subject to change up until a final standard is produced. It is also worth saying that the current UK GAAP regime is also in the process of being changed from 2015. In the particular case of insurance a new standard for accounting for insurance under UK GAAP is currently being developed by the Accounting Council and there is still a lot of debate surrounding this. If you are interested in the IFRS proposals, you can find more information on the International Accounting Standards Board website, www.iasb.org.uk.

ST7-24: Accounting methods Page 18b


3 Funded (three-year) accounting

In Section 2 we saw how one-year accounts are based on the premiums earned within a year. The structure of funded accounts is quite different. Funded accounts are based on premiums written in a given year. The premiums for policies written in a particular year are kept in a special fund for a period that is specified at outset. The most common period is three years, hence the alternative name of three-year accounts. At the end of the third year the profits for that particular block of business are assessed. This chapter and the Core Reading use the terms funded accounting and three-year accounting interchangeably. However, it is important to remember that other accounting periods (eg two or four years) are also used on a funded basis.

3.1 Example of three-year accounts

Suppose an insurer commences business on 1 January 2011, accounting for profits on a three-year basis. All the premiums for business written in 2011 are notionally kept in a separate fund and all claims and expenses relating to this business are paid from this fund. We shall refer to the amount in this fund at time X as Fund2011,X At the end of the first year of trading (ie at the end of 2011), there is one fund of amount Fund2011:31/12/2011 During 2012, a new fund is started which will hold all premiums and cover all claims and expenses in respect of business written in 2012. Note that the 2011 fund will still be maintained to account for premiums, claims and expenses relating to business written in 2011. At the end of 2012 there will be two funds: Fund2011:31/12/2012 and Fund2012:31/12/2012. A third fund is opened on 1 January 2013 for business written in 2013. All the premiums, claims and expenses for these policies are accounted for within the 2013 fund. The convention with funded accounts is to “close” a fund at the end of its third year. (Hence, “three-year accounts”.) So at 31 December 2013, the 2011 account will be closed.

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ST7-25: Interpreting accounts Page 3


Prudence has been described as the inclusion of a degree of caution in the exercise of the judgements needed in making the estimates required under conditions of uncertainty, such that gains or assets are not overstated and losses or liabilities are not understated. We may interpret this as meaning that the greater the uncertainty, the greater should be the tendency to aim at reserves exceeding the expected value of the liabilities, as a natural consequence of seeking to avoid understating the liabilities. Under IFRS Phase II there is a proposal that the measurement of insurance liabilities should reflect risk to the extent that it would be reflected in the price of an arm’s length transaction between knowledgeable, willing parties. This is not a component of current GAAP or IFRS. The proposal under Phase II is to value liabilities at the discounted probability-weighted value of cash flows plus:

a risk margin amount or margin reflecting an assessment of uncertainty associated with insurance risk, and

a residual margin the expected profit or loss of a contract at outset, excluding excess investment returns and risk margins.

This was discussed in Chapter 24, Accounting methods.

Question 25.1

General insurers have historically not discounted their reserves. Do you think that this practice has been consistent with the interpretation of prudence described above?

The reason for constructing the accounts will influence the size of margins that will be included in the accounts. Accounts that are produced to demonstrate solvency are likely to be prepared on a more cautious basis than those prepared for management, which are produced to give a realistic picture of the profitability and financial strength of the company. In addition, the concept of prudence under IFRS Phase II is different from that under UK GAAP, in that it does not allow the creation of hidden reserves or excess provisions by the deliberate understatement of assets or income or the deliberate overstatement of liabilities or expenses.

a ST7-25: Interpreting accounts


Under IFRS, an insurer need not change its accounting policies for insurance contracts to eliminate excessive prudence. However, if an insurer already measures its contracts with sufficient prudence, it shall not introduce additional prudence. Introducing additional prudence would not make the accounts more reliable or relevant and vice versa, and therefore the change would not be allowed. Other than as described in this chapter, candidates for Subject ST7 examinations will not be expected to be familiar with the accounting concepts and principles that apply in any particular country. They may, however, be expected to discuss the problems that arise in defining such concepts and principles and putting them into practice, and the implications for the interpretation of insurers’ accounts.

ST7-25: Interpreting accounts Page 4b


2 Interpreting accounts

Before attempting to interpret the accounts of an insurer, we should become familiar with the statutory rules governing the preparation of the accounts and the accounting rules and conventions that apply in the country concerned. This paragraph can be related back to the actuarial control cycle. Before we can monitor the experience of an insurer, we should be familiar with the economic and commercial environment in which the insurer operates. Though subject to some variation from country to country, the published financial statements of insurers are usually prepared on a going concern basis and are intended to give a true and fair view of the insurer’s performance and financial position. We should examine them to see whether they have been affected by any changes in accounting practice and, if so, to find what the effects of such changes may have been. We should consider the basis used for the valuation of the assets and the treatment in the accounts of realised and unrealised capital gains and losses. If assets are shown at market value, we should consider the vulnerability of the asset values to changes in market conditions. Let’s consider Company A and Company B and for each company calculate the solvency ratio, a useful measure of financial strength. The solvency ratio is defined as free reserves divided by net written premiums.

Company A Company B

Total assets

Total liabilities

Net written premiums

Solvency ratio

£740m

£650m

£500m

18%

£740m

£615m

£500m

25%

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ST7-25: Interpreting accounts Page 7


But if we discovered that:

Company Y writes more volatile business

Company Y discounts claim reserves and has few margins

Company X assesses reserves with very large contingency margins

… then we might establish that Company X was in fact much stronger. For example, if the liabilities of both companies were to be assessed on a consistent and moderately conservative undiscounted basis, the results might be:

Company X Company Y

Total assets £260m £260m

Total liabilities £160m £200m

Net written premiums £300m £300m

Solvency ratio 33% 20%

Profitability Different reserving bases can also distort the picture for profitability. However, it is much less clear whether profit will be understated or overstated.

Question 25.3

Is it true that a company with a strong reserving basis will always show smaller profits than an equivalent company with a weaker reserving basis?

Conclusion The strength of the reserving basis can have a distorting influence on the apparent financial strength and apparent profitability. We may be able to get an indication of the strength of the reserves by examining individual accounting items (both gross and net of reinsurance if separate figures are available) and various ratios of these accounting items, and comparing them with their counterparts in the accounts of earlier years. The extent to which this is feasible will depend on the amount of detail given in the financial statements.

ST7-25: Interpreting accounts


There are some useful disclosures that are normally present in any set of accounts, such as:

triangles in the case of IFRS

fair value hierarchy of investments to check asset valuations and their potential volatility

disclosures around reserves to work out reserve releases / deterioration etc.

Among the ratios that we may consider are:

incurred claims to premium income

incurred expenses to premium income

commission to premium income

operating ratio / combined ratio

outstanding claims reserve to claims paid

outstanding claims reserve to premium income

outward reinsurance premium income to gross premium income

reinsurers’ share of reserves to gross reserves. A sharp rise in premium income may be a sign of competitively low, and perhaps unprofitable, premium rates. It may also affect the progression of other items such as the ratio of the reserve for outstanding claims to the earned premiums, the new business strain and the statutory minimum solvency margin. In the next section we will look at the key values and ratios that might be considered when analysing a general insurer’s accounts including the ratios mentioned above.

ST7-26: Regulation Page 9


Timeline for implementation There are two implementation dates for Solvency II, one for regulatory authorities and one for insurance companies. It is currently expected that the Solvency II responsibilities of supervisors and EIOPA (the European Insurance and Occupational Pensions Authority) will be switched on with effect from 1 January 2014. Solvency II requirements would be switched on for companies on 1 January 2016. These dates have not yet been finally agreed.

4.2 Development of Solvency II

Lamfalussy process The new Solvency II framework has been created in accordance with the Lamfalussy four-level process. The Lamfalussy framework was drawn up by the “Committe of Wise Men” in 2001, chaired by Baron Alexandre Lamfalussy. It is basically a step-by-step guide on how to introduce new legislation. It allows legislation to be developed and implemented gradually over a period of time. The four stages of the Lamfalussy process are: ● Level 1 developing an EU legislative instrument that sets out the key

framework principles, including implementation powers (completed in 2009 but with amendments planned in October 2013)

● Level 2 developing more detailed implementing measures and technical

standards (to be finalised when level 1 is agreed) ● Level 3 developing supervisory guidance and common standards, and

conducting peer reviews and consistency comparisons (to be finalised when level 2 is agreed)

● Level 4 enforcement across the Member States (to be finalised when

level 1 is agreed).

ST7-26: Regulation


Development has been supported through a number of Quantitative Impact Studies (QIS) that insurance companies have been asked to complete, and through liaison with national supervisory bodies. EIOPA has provided technical advice and support to the European Commission for the development of the implementing measures under Level 2, and is responsible for producing the Level 3 additional guidance. (EIOPA is the European Insurance and Occupational Pensions Authority and is one of the EU’s main financial supervisory bodies and was previously known as CEIOPS.) Solvency II will be discussed in considerably more detail in Subject SA3.

ST7: Q&A Bank Part 6 – Questions Page 7


(a) Using the method of moments to fit a normal distribution to the data, estimate the required pure premium for a stop loss layer 15% excess of 85% loss ratio for 2014.

(b) Estimate the required pure premium for a stop loss layer 20% excess of

100% loss ratio using a log-normal distribution.

Hint: You should use the expressions given following part (iv) below for the limited expected value function. [6]

(iii) Draw a rough bar chart of the data and explain which distribution you would

choose for setting rates. [3] (iv) It is suggested that rates on the business have deteriorated over the period. (a) Discuss briefly whether the data suggest that this is true. (b) Outline how you would allow in the calculation of the stop loss premium

for any such decline in rates. [4] Note For a random variable X with density function f(x) and distribution function F(x) the limited expected value function E(X;x) can be expressed as:

( ) (1 ( ))x

yf y dy x F x-•

+ -Ú

The limited expected value E(X;x) for each distribution can be evaluated as follows: Normal

( ; ) 1x x x

E X x xm m mm sf

s s sÊ ˆ- - -Ê ˆ Ê ˆ Ê ˆ= F - + -FÁ ˜ Á ˜ Á ˜Á ˜Ë ¯ Ë ¯ Ë ¯Ë ¯

Log-normal

2 2log log

( ; ) exp 12

x xE X x x

s m s mms s

Ê ˆ Ê ˆ Ê ˆ- - -Ê ˆ= + F + -FÁ ˜Á ˜ Á ˜ Á ˜Ë ¯Ë ¯Ë ¯ Ë ¯

where F is the distribution function of the standard normal and f the density function

of the standard normal distribution with mean m and standard deviation s .

[Total 18]

ST7: Q&A Bank Part 6 – Questions


2 Exam-style questions

Question 6.19

An insurance company that writes only motor insurance has a financial year running from 1 January to 31 December. On 1 May, a broker sold an annual policy with a premium of £450. The company received the premium, net of 14% commission, on 15 June. No claims were made under the policy. In addition to the commission, the marginal costs incurred from this policy totalled £10 on acquisition and £1 at the start of each month thereafter, finishing on 1 May one year later. The company earned 1% per month on its assets in the first calendar year (ie from 1 May to 31 December), and 0.8% per month in the second year (ie 1 January to 30 April). Assume that the company prepares its accounts on the basis of acquisition costs being 20% of written premium, and that IBNR is calculated on a very crude basis, namely as 5% of premiums earned in the year. (i) Stating all further assumptions and ignoring the impact of taxation, show how

this individual policy will affect the company’s accounts for each of the two calendar years in question. [15]

(ii) Explain, in detail, how your answer would differ if the company decided at the

end of the first calendar year that for policies written during that year, the premiums would be inadequate to cover the claims that would emerge from the policies in future. [4]

[Total 19]

ST7: Assignment X1 Questions Page 3


Question X1.8

You are the actuary with an insurer that has experience of writing motor insurance over a number of years. The insurer is considering establishing a separate class for classic motor vehicles (ie collectors’ items).

(i) By considering each risk factor, discuss how the risk arising from policies in this class might differ to that arising from standard motor insurance. [7]

(ii) Describe how the company’s approach to new business acquisition may have to

change. [3] [Total 10] Question X1.9

List the factors relating to the external environment that may affect claim frequencies or amounts for motor insurance policies. [6]

End of paper

ST7: Assignment X1 Questions


This page has been left blank so that you can slot the replacement pages into your X Assignments

ST7: Assignment X1 Solutions Page 15


Other focused ways of selling policies are:

making special arrangements with affinity groups such an owners club [½]

setting up a stall at classic car rallies [½]

through specialist motor brokers [½]

through other specialist motor organisations. [½] [Maximum 3] Solution X1.9

Comment This question is testing your ability to apply the ideas in Chapter 7, External environment. Both claim frequencies and amounts ● a change in speed limits [½]

● a change in the use of speed cameras [½]

● a change in societal trends, eg a reduction in drink driving [½]

● an unusually severe winter [½]

● the introduction of speed-restricting technology in vehicles [½]

Claim frequencies ● an increase in crime rates [½]

● a change in the effectiveness of car security systems [½]

● a change in the stringency of driving tests [½]

● a change in attitudes to claiming, leading to an increase in the frequency of liability claims [½]

ST7: Assignment X1 Solutions


Claim amounts ● tax on car parts [½]

● legislation increasing the amount of cover that must be provided [½]

● legislation requiring the use of car safety equipment (eg seat belts or children’s seats), leading to a decrease in the cost of bodily injury claims [½]

● publicity regarding a fault with a particular make of car (eg a batch of cars sold with faulty brakes), leading to higher court awards for compensation [½]

● a shortage of mechanics, leading to an increased cost of labour [½]

● a change in procedures for building / repairing cars, leading to a change in the cost / ease of repairing cars [½]

● a change in driving habits (eg an increase in motorway driving and a decrease in driving in city centres) – this may be due to factors such as congestion charges

[½]

● a change in economic growth (eg in a recession, fewer people may buy big, new, expensive cars, so the average claim size may fall) [½]

● a change in the rate of price inflation [½]

● a change in the rate of court award inflation [½]

● a change in exchange rates, which may affect the cost of claims made overseas (ie people driving their cars abroad) [½]

[Maximum 6]



● incomplete, ie data fields missing, due to: [½]

– poor systems design [½]

– poor user processes [½]

– inadequate information collected at outset by the insurer [½]

– inadequate information collected at outset by third parties [½]

● nonexistent data for: [½]

– new class of business [½]

– new territory (may occur because of globalisation of markets) [½]

– unusual risks [½]

– infrequent claim events [½]

– certain rating groups (eg very old people, unusual classes) [½]

– extreme values (where data does not exist or is too volatile to be usable) [½]

● data not completely relevant due to changes in: [½]

– external factors (eg global weather patterns) [½]

– policy terms and conditions [½]

– underwriting philosophy [½]

– claims management processes [½] [Maximum 10] Solution X2.3

Comment This question is testing Chapter 9, Modelling uncertainty. You should consider all the components of an insurer’s return, eg premiums, claims, expenses etc. Premiums may not be enough to cover the expected claim cost. [¼] This may be due to:

● the underwriting cycle leading to lower rates [¼]

● anti-selection if the rating structure is incorrect [¼]

● inadequate data upon which to price the risks. [¼] Premiums could be too high, leading to lower than expected volumes of business and a failure to adequately cover fixed expenses. [½] Claims experience may be higher than expected. [½]



This could be due to:

● catastrophes

● latent claims

● aggregations of risk

● poor policy wording

● higher than expected claims inflation

● unfavourable judicial decisions. [¼ each, total 1½] Higher than expected expenses, commission or expense inflation. [1] Low investment income, falls in assets values or increased taxation of returns. [1] Other possibilities:

● adverse currency movements

● failure of third parties, eg reinsurers

● changes in legislation

● mis-management of the syndicate. [¼ each, total 1] [Maximum 6]



… but there is not always sufficient credible data to enable this. [½] [Maximum 3] (ii) Parameter uncertainty This is the uncertainty that arises when choosing the parameters for the model. [½] It is a result of the statistical variability in the past data used as a starting point for setting the parameters … [½] … for example due to the presence in the past data of an unusually large claim. [½] Parameter uncertainty can be reduced by exercising actuarial judgement when selecting parameters … [½] … although this uncertainty can never be removed completely. [½] [Maximum 2] (iii) Process uncertainty This is the uncertainty that arises because of the inherent randomness of the process being modelled. [½] It would exist even in the absence of model and parameter uncertainty. [½] The process uncertainty is reduced if modelling large numbers of reasonably independent risks … [½] … but will be unavoidable when modelling small numbers of correlated risks. [½] [Total 2]

a ST7: Assignment X4 Solutions


Solution X4.4

Comment This topic is covered in Chapter 14, Stochastic reserving models. Correlations between lines of business Lines of business can be correlated because:

● they are impacted by similar events, eg a windstorm could impact both household and commercial property accounts [½]

● legal changes can affect several lines of business, eg a change in the discount rate required to calculate bodily injury awards would affect both employers’ liability and motor classes [½]

● the same claims team may handle claims from several lines of business and so changes to claims handling may impact on more than one line [½]

● problems with data may affect more than one line of business. [½] [Markers, award ½ each for any distinct reasons, up to a maximum 2.] Allowance for correlations in a stochastic model A correlation matrix could be used ... [½] ... however this only allows for very simple dependencies between classes. [½] A copula is a more flexible approach, because it allows for multiple dependencies. [½] For example, the Gumbel copula and the t-copula allow for increased correlations in the tails of the distribution. [½] However, it can be difficult to parameterise dependencies from data, so judgement is important. [½] The user must specify:

● underlying loss distributions for the classes of business [½]

● a two-way correlation matrix between all distributions [½]

● the form of the copula. [½] [Maximum 4]

ST7: Assignment X4 Solutions Page 4b


Solution X4.5

Comment The Core Reading for this question is covered in Chapter 16, Reserving use of ranges and best estimates. The key points to consider when communicating a best estimate reserve are:

● Who the recipients are, their level of knowledge and how they will use the information. [1]

● How we get across that the best estimate is just an estimate … [½]

● … that there are other possible reasonable estimates … [½]

● … that the actual result is likely to be different from the best estimate. [½]

● How we clarify that the best estimate is just the mean of the distribution ... [½]

● … it will not necessarily reflect the most likely outcome … [½]

● … particularly if the distribution is positively skewed. [½]

c ST7: Assignment X4 Solutions



ST7: Assignment X6 Questions Page 1


Question X6.1

A general insurance company has been selling steady volumes of business for many years. The company has the following reinsurance treaties in place:

● A quota share arrangement under which 60% of the business is ceded. The reinsurer pays the insurance company an override commission of 7% of the reinsurance premium.

● A 10-line surplus treaty, with a maximum retention limit of £1m.

● An excess of loss treaty that pays 90% of all losses above £0.5m, the premium for which is calculated as 3% of the insurer’s gross written premium.

The treaties operate in the order given. (i) Give a formula that, for a surplus treaty, relates the expected maximum loss

(EML) to the retention (r) and number of lines (l). [1] (ii) A company director has written asking if you can give him an indication of the

maximum amount that the company would have to pay out as a result of an individual claim. Set out the points that you would make in reply. [4]

(iii) Comment on the suggestion: “The quota share treaty is better than the excess of

loss treaty since the quota share treaty pays commission whilst the excess of loss treaty costs the insurer. This must also mean that the excess of loss reinsurer is making more profit than the quota share reinsurer.” [5]

[Total 10] Question X6.2

(i) State the objectives of regulation. [3] (ii) List the key activities of the IAIS. [1] (iii) List the capital requirements that an insurance supervisor might impose on an

insurer. [3] (iv) Describe the disadvantages to insurers of complying with the IAIS Core

Principles (ICPs). [3] [Total 10]

ST7: Assignment X6 Questions


Question X6.3

A general insurance company, which writes only direct business, accounts for all its business on an accident-year basis. Comparison of the company’s solvency margin (excess of assets over liabilities) with the solvency margin for other direct insurers shows that the company’s solvency margin has fallen, whereas the margin for most other companies has risen. Explain the extent to which comparison of the solvency margin of different insurance companies can validly be made, and describe the factors that would need to be taken into account if the purpose of the comparison were to establish the likelihood of future insolvency. [14] Question X6.4

You are a consultant actuary. One of your clients is considering the purchase of a general insurer that only sells motor business. Initially, you have been given two years’ accounts for the insurer, which are as follows:

Year X Year X+1

Written premiums 15.0 16.0

Earned premiums 14.5 15.5

Claims paid 16.0 12.0

Increase in o/s claims reserves –5.5 1.5

Expenses paid 1.5 1.6

Increase in DAC 0.1 0.1

Investment income 9.0 4.0

Tax 2.9 1.1

Dividends 7.0 7.5

Retained profit 1.7 – 4.1



Assignment X6 Solutions Solution X6.1

Comment This question tests your understanding of the material in Chapter 22, Determining appropriate reinsurance, as well as building on your understanding of Surplus reinsurance, from Chapter 5, Reinsurance products (2). (i) Formula (1 )EML n r [1]

(ii) Maximum loss There is no maximum amount that the company could lose. Theoretically, losses are infinite. [½] For anything above £0.5m, (net of quota share and surplus) the insurer only pays 10% of the excess. There is reduced, but still unlimited, liability above this cut off point. [½] The size of the original, gross of reinsurance claim that would result in a net (of quota share and surplus) claim of £0.5m is dependent upon whether the surplus treaty is used and the number of lines used. [½] A gross claim as small as £1.25m would result in a net claim of £0.5m if no surplus lines were used, but a claim as high as £13.75m could also result in a net claim of £0.5m if the full 10 lines were used. [1] Although the maximum retention under the surplus treaty gives no guaranteed maximum that we reasonably expect to lose, it does give a reasonable indication. [½] In this case the maximum is £1m, net of the quota share treaty. [½] If a claim for this “maximum” of £1m did come in the insurer would pay £0.55m. [½] All of these figures assume that the reinsurers stay solvent. If any of the three reinsurers default, the amount could rise sharply. [½] [Maximum 4]



(iii) Comment on suggestion The quota share arrangement does pay override commission … [½] … but only to reimburse the insurer for the costs associated with setting up and servicing the reinsured policies (eg underwriting, pricing, new business administration). [½] So the “benefit” of the commission is only to compensate for costs that the insurer has incurred. [½] With excess of loss the insurer keeps all the profit that is loaded into its premium rates. [½] However, the “cost” of reinsurance is loaded into the premium paid. [½] When deciding which is “best” we must think about the benefits of reinsurance – not just the costs. [½] There could be other benefits, eg technical assistance, although this is more likely to come from the broker rather than the reinsurer. [½] The key benefit of excess of loss is to protect the company’s solvency (and stability of profits) against large claims. [½] Quota share would not be so effective in this respect – so how can you say that it is better? [½] It is impossible to say which reinsurer is making the most profit. We should look at a “risk-adjusted” profit. The excess of loss reinsurer may be taking more risk. [1] [Maximum 5] Solution X6.2

Comment This is a Core Reading question from Chapter 26, Regulation. (i) Objectives of regulation Key objectives of regulation and supervision are to promote efficient, fair, safe and stable insurance markets and to benefit and protect policyholders. [1]



Further objectives include:

● enhance overall efficiency of the financial system [¼]

● reduce transaction costs [¼]

● create liquidity [¼]

● facilitate economies of scale [¼]

● encourage economic growth [¼]

● help allocate resources efficiently [¼]

● manage risk [¼]

● encourage long-term savings. [¼]

[Total 3] (ii) Key activities of IAIS The IAIS:

● issues global principles, standards and guidance papers [½]

● provides training and support on issues related to insurance supervision, and [½]

● organises meetings and seminars for insurance supervisors. [½] [Maximum 1]

(iii) Capital requirements Examples of regulatory capital requirements include:

● requirement to deposit assets to back claims reserves [½]

● requirement to maintain a minimum level of solvency [½]

● use of prescribed bases to calculate premiums, asset values and liabilities to demonstrate solvency [½]

● requirement to hold a claims equalisation reserve [½]

● the use of prescribed bases to calculate premiums, asset values and liabilities to demonstrate solvency [½]

● requirement for risk-based capital calculations and ICA analyses [½]

● requirements in respect of the capital model, eg the requirement to satisfy the “use test”, so that the capital model and results should be used to help manage the business. [½]

[Maximum 3]

a ST7: Assignment X6 Solutions


(iv) Disadvantages of complying with IAIS ICPs Disadvantages include:

● valuations may be less prudent, eg where the regulation requires assumptions to be based on actual experience, without including margins [½]

● a risk-based approach could increase the volatility of results, leading to: [½]

– more volatile distribution of profits [¼]

– reduce the availability of capital [¼]

● broader reporting requirements may mean that intra-group arrangements will have to be disclosed [½]

– this may bring further disadvantages, eg tax implications for arrangements that take place across different territories [¼]

● increased costs of regulatory supervision, which may be passed onto insurers via increased levies [½]

● increased costs of compliance [¼]

● loss of market confidence if insurers are seen not to comply with recognised best practice. [½]

[Total 3] Solution X6.3

Comment The Core Reading for this question is covered in Chapter 25, Interpreting accounts. Comparison can validly be made between the solvency margins of two companies, but there are many factors that will distort this comparison. These factors should be taken into account where possible, ie comparison can only be made to a limited extent. [1] Factors to take into account when comparing the solvency margins In the text below, “less risk” implies that there is a lower likelihood of insolvency. Size of margin Larger margin stronger office [½]

Smaller margin more risk [½]

ST7: Assignment X6 Solutions Page 4b


Size of margin in relation to variation in outgo More business more risk (so bigger margin needed) [½]

Often quote required solvency margin as proportion of written premiums [½]

Required margin depends on classes of business (affecting the variability of outgo) [½] Diversification Smaller unit size of policies less risk [½]

Fixed benefit classes less risk [½]

Greater geographical spread less risk [½]

Wider spread of business mix less risk [½]

Suitable spread of investments less risk [½]

More business usually means wider spread less risk [½] Asset values If assets are valued on a mark-to-market basis, then a company with a bigger proportion of assets that are temporarily undervalued by the market might be less risky than would appear from the published returns. [1]

c ST7: Assignment X6 Solutions



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