Part 6

Question 1

The principles of investing

Answer 1

a. Should select assets that i. Minimise risk ii. Appropriate in nature, term and currency of liabilities b. Maximise overall return, where the overall return includes investment income and capital gains c. The extent to which the appropriate investment referred to above may depart from in order to maximise the overall return will depend on the extent of the company’s free assets and the company’s risk appetite

Question 2

|Asset- liability matching requirements

Answer 2

• Nature, term and currency of liabilities
  
  • Guaranteed in money terms
  • Guaranteed in terms of index
  • Discretionary
  • Investment linked
• Term
  
  • Select assets that have a similar DMT (discount mean term) to the liabilities.
  • This ensures that assets move in line with liabilities. Immunisation
• Currency
• Mismatching and demonstrating solvency
  
  • Cashflow mis-matching risk is when over time, the income from assets falls short of the outgo needed to meet liabilities.
  • This could be due to yields are lower than expected or selling assets at a lower price
  • Short term risk is the risk that company is not able to meet its supervisory reserve requirements.
  • This could be caused by short term market shocks
• Effects of the nature of liabilities
  
  • Guaranteed in money terms
    
    • Assets need to match
    • Immunisation technique could be used
  • Guaranteed in terms of index
  • Discretionary
    
    • Invest in more risky assets
    • Company will have to take into account policyholder expectation
    • Not the most risky, that is unit linked product
    • The assets will depend on
      
      • Philosophy
      • Risk appetite
      • Free assets
      • Policyholder’s expectation, based on marketing material
  • Investment linked
    
    • Free assets
    • Only have this if liabilities are sufficiently matched
    • May depend on policyholder’s expectation

Question 3

Process splitting the costs

Answer 3

1. Start form the recent expense data
2. Adjust any old data for inflation to bring it up to date
3. The expense will need to be divided into direct and overhead expenses
4. It is unlikely for there to be a clear dividing line between direct and indirect and so some judgement will have to be made
5. Any commission would normally be excluded from the analysis, on the basis that its format is known and can be allowed for explicitly
6. The non-commission expenses would then be split into initial, renewal, termination and investment expenses
7. For initial, renewal and termination we can further split the data according to whether the expense is proportional to
   
   1. Number of contracts written or in force
   2. The amount of benefit written or in force
   3. Amount of premium written or in force
8. Most of the expenses will be assumed to be proportional to the first of these
9. Investment expense would probably be expressed as a percentage of funds under management and then treated as a deduction from the earned investment return
10. The expenses would be split down further into smaller cells, where practicable, for example by accounting fund and/or by product line or policy type.
11. Cells should not be so small that the analysis becomes unreliable

Question 4

Analysis of surplus. This is done so that

Answer 4

• Assess the financial effect of A vs E of writing new business
• Check which assumptions are more financially significant
• Valuation check
• Assistance with bonus distribution
• Provide an independent check on the valuation data and process
• To give management information on trends in the experience of the company and so help in identifying appropriate corrective action
• Information on trends
• To assist on deciding executive remuneration h. Analysis of embedded value profit
• Validate the calculations assumptions and data used
• Reconcile the values for successive years
• Provide management information
• Provide data for use in executive remuneration schemes
• Provide detailed information for publication in company accounts
• Validation of calculations, assumptions and data
• Data used for executive remuneration schemes ii. Information accounts
• Identify non recurring components of surplus, thus enabling appropriate decisions to be made about the distribution of surplus to with profit policyholders
• Divergence of actual vs expected (show financial effect /significance of) Information to management and for accounts
• Variance of whole is equal to the sum of the variances from the individual levers
• Experience monitoring to feedback into ACC
• Reconcile values for successive years Group into one-off / recurring sources of surplus
• Executive remuneration schemes (data for)
• New business strain (show effects of)
• Check on valuation assumptions and calculations
• Extra check on valuation data and process

Question 5

Explain the type of insurance available

Answer 5

• Catastrophe Available on a yearly basis and must be renegotiated each year.
• Reinsurering company will agree to pay out if a “catastrophe”, as defined in the reinsurance contract, occurs.
• There is no standard definitation of what constitutes a catastrophe, but typically to qualify there needs to be a minimum number. e.g. number of deaths from a single event within a fixed time from event
• Reinsurers will pay up to a maximum amount that the reinsurer will pay for one event, it may be that only a proportion above the initial amount is paid by the reinsurer.
• Any amount above the limit reverts to the insurer. There is also usually a maximum amount of cover per life. War, epidemics and nuclear disasters are usually excluded.
• Catastrophe reinsurance reduces the potential loss due to non-independence of the risks Separate catastrophe covers may be available for excluded risks.
• Typically catastrophe covers low frequency events that have a high impact.

Question 6

How to allocate the staff costs

Answer 6

1. This can be split into
2. Staff whose work comes entirely within a single cell of the analysis. The salaries can be directly allocated to the appropriate cell
3. Staff whose work comes within several cells. The timesheets could be used to split their salaries between appropriate cells
4. Staff whose work does not directly relate to any particular cell or cells.
   
   1. The salaries will be a mixture of both overheads and direct expenses, and some pragmatic approach will probably need to be taken to split theses.
   2. The direct part of these salaries can be allocated to cell level
   3. for indirect, the expense is split in proportion to the direct expenses already identified

Question 7

How to allocate Property costs

Answer 7

1. Property costs
2. If the company owns, as an asset of its long term fund, any of the buildings that it occupies, a notional rent needs to be charged to the relevant departments
3. This rent, plus property taxes, heating , lighting, cleaning costs can be split for example in proportion to the floor space occupied between departments and then allocated according to salaries
4. Depending on the work performed by each department the cost is included in either the initial, renewal or claims expenses.
5. The split may be carried out at a more granular product level based on the work performed on each product.
6. If part of the office is rented to a third-party allowance should be included in the costs.

Question 8

How to allocate other costs including 1 offs

Answer 8

1. Computer costs
   
   1. The cost of purchasing a new computer would be amortised over its useful lifetime and then added to the ongoing computer costs, These can then be allocated according to the computer usage
   2. The amortised cost would be separated into new business functionality, on-going administration costs and claim costs.
   3. The cost would then be included in either the initial, the renewal or the claims expenses, respectively.
   4. The split may be carried out at a more granular product level based on the work performed on each product.
2. Other one off capital costs
   
   1. Large one off capital costs would generally be excluded at the time of purchase.
   2. Instead, the cost would be amortised over the expected useful lifetime of the item and included as part of the overheads each year during that time period
   3. The split may be carried out at a more granular product level based on the work performed on each product.
3. Investment costs
   
   1. The investments costs would be directly allocated as investment expenses and dealt with as already described above. There is no definitive approach to splitting the others

Question 9

Assets backing Unit linked business

Answer 9

• The benefit is investment linked.
• The assets held to back the unit fund are likely to be the assets in the fund selected by
  the customer…
  
  • …as most regulations restrict mis-matching on unit funds.
• The assets backing the non-unit reserve will need to be liquid assets…
  
  • …as the non-unit reserve covers any short fall between charges and expenses.
  • Hence cash or near cash instruments are likely to be held.
  • … and potentially suitably liquid bonds of ten year term.