ST1: CMP Upgrade 2016/17 Page 1

Subject ST1
CMP Upgrade 2016/17

CMP Upgrade

This CMP Upgrade lists the changes to the Syllabus objectives, Core Reading and the
ActEd material since last year that might realistically affect your chance of success in
the exam. It is produced so that you can manually amend your 2016 CMP to make it
suitable for study for the 2017 exams. It includes replacement pages and additional
pages where appropriate. Alternatively, you can buy a full set of up-to-date Course
Notes / CMP at a significantly reduced price if you have previously bought the full-
price Course Notes / CMP in this subject. Please see our 2017 Student Brochure for
more details.

This CMP Upgrade contains:

all significant changes to the Syllabus objectives and Core Reading.

additional changes to the ActEd Course Notes, Question and Answer Bank and
Series X Assignments that will make them suitable for study for the 2017 exams.

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1 Changes to the Syllabus objectives

This section contains all the non-trivial changes to the Syllabus objectives.

An additional bullet point has been added to Objective (l) as follows:

(l) Describe the purposes of reserves, solvency capital requirements and embedded
values, and the methodologies by which they are calculated for a health and care
insurer, including:

● role of statistical and individual case estimates

● setting assumptions, including a comparison with those used in pricing
● market consistent valuation
● the interplay between the strength of the supervisory reserves and the
level of solvency capital required
● Value at Risk (VaR) capital assessment
● comparison of passive and active valuation approaches.

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2 Changes to the Core Reading

This section contains all the non-trivial changes to the Core Reading.

General

There have been a number of additions of the word “insurance” after “income
protection” (or “IP”) and “critical illness” (or “CI”).

There are a number of incidences of the word “healthcare” that have been changed to
“health and care”.

Chapter 2

Page 9

The first two sentences under “Other conditions” have been shortened to read:

Given below is a list of those non-major conditions that will perhaps be included:

Chapter 4

Pages 8-9

The material on health cash plans has been amended. Replacement pages are attached.

Chapter 8

Pages 8-11

There have been a number of changes to the material on commission. Replacement

pages are attached.

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Chapter 11

Page 16

The first sentence under “Value of premiums” has been amended as follows:

The value of one unit of premium income would be projected and discounted,
allowing for escalation as appropriate, persistency rates and premium waiver
during claim, if appropriate.

Page 19

The first sentence under “Value of tax and other outgo” has been amended as follows:

This can be allowed for by adjusting the discount rate, though explicit allowance
may be made for the impact of tax on other specific elements of the basis
eg expenses or profit.

Page 22

The fifth and sixth bullet points have been amended as follows:

contribution to reserves
contribution to capital requirements

Page 23

The paragraph of Core Reading on this page has been amended to read:

The net cashflow may be investigated for the possibility of negative flows and
hence the potential need for additional reserves.

Chapter 12

Page 2

The first paragraph of Core Reading has been amended to read:

The most important component of the premium that is charged to the customer
is generally that which covers the pure risk ie the anticipated cost of claims for
the future period for which the policy is to be in force.

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The final sentence of Core Reading has been amended to read:

The actuary will then employ skill and judgement in projecting the data, in order
to estimate the future claims experience and thus the premium that should be
charged to the policyholder.

Page 4

The final paragraph of Core Reading has been amended to read:

For private medical insurance, the average claim size will be a function of
inflation, current protocols and hospital charging structures, as well as the
availability of treatments and care under any State healthcare system; but here
we need only look at a year at a time, because premium rates are typically
reviewed annually, and policies are renewed once a year.

Page 6

The second sentence of Core Reading in the section on “Relevance” has been amended
to read:

There are many influences affecting the amount to be paid out in benefits that
are specific to the insurer in question and so may not be reflected in numbers
taken from external sources, for example:

Page 8

The first bullet point has been amended to read:

● The accuracy and reliability of the national statistics may be questionable,

especially in healthcare where definitions may be subjective and the
scope for double counting is significant.

Chapter 13

Page 9

The third bullet point has been amended to read:

● the company’s attitude to risk or risk appetite

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Page 12

The second paragraph in Section 3.3 has been amended to read:

Here assumptions will be derived based on the actuary’s best estimate of future
realistic experience, without the incorporation of any prudential margins. The
basis derived will be similar to that used for new business pricing.

Page 16

The first bullet point has been amended to read:

● to establish a value of the business, possibly for internal management

accounts or information

Chapter 14

Page 19

The first bullet point has been amended to read:

● Firstly, an early lapse may cause financial loss, where insufficient

premiums have been received to recover the initial strain (commission
and initial expense) involved in writing the policy.

Chapter 18

Page 7

The first paragraph of Core Reading in Section 3.2 has been amended to read:

The term credibility relates to the factor, between 0 and 1 inclusive, which
represents the proportion of the final risk premium that is derived from past
experience, the balance coming from book rates.

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Chapter 19

Page 10

The first two paragraphs of Core Reading in Section 3.3 have been amended to read:

In order to ensure products are competitive, and to gain market share, the
actuary may be in a position of having to barter on margins within contracts.
Commercial decisions may have to be taken to price a healthcare insurance
product at a lower profit margin.

In order to maintain aggregate profitability, it is necessary that other lines be

costed with additional margins, to subsidise the low margin class of policy. This
again is purely a matter of taking a wider portfolio perspective of profitability.
The actuary will need to monitor the volumes in each class to ensure that, as
new business is taken on, the margins foregone in one line are adequately met in
another.

Chapter 21

Pages 2, 27, 33 and 41

Material has been added on active and passive valuation methods. Replacement pages
are attached.

Page 12

The first paragraph of Core Reading in Section 3.3 has been amended to read:

For most forms of long-term insurance, the amount of benefit payable is known
once a claim is submitted. However, for contracts that pay income, the duration
for which benefits will be paid will not generally be known at the point a claim is
submitted. This is typically true of IP insurance and LTCI, but not CI insurance.
The insurer will hold a reserve for claims that have been notified but not yet
settled, using the amounts in the policy document, increased where appropriate
by relevant inflationary indices or other increments.

Page 13

The first paragraph of Core Reading in Section 3.4 has been amended to read:

Private medical insurance is typically an indemnity cover, ie the amount payable

on claim is determined by the costs incurred by the claimant and thus is not
known with certainty until the particular course of treatment is complete.

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Chapter 22

Page 10

The second paragraph of Core Reading in Section 2.3 has been amended to read:

The average cost of claim will vary as inflation increases costs year on year and
as the mix of the insured members changes (eg by age, health status, location).
Additionally, however, claims costs will vary as different medical procedures are
performed to treat the same conditions (as medical science and recommended
protocols progress), as hospital capacity changes the likely stay as in-patient for
a given procedure, and as pricing agreements are negotiated and re-negotiated
with providers.

Page 11

The following paragraph of Core Reading has been added after the second paragraph of
Core Reading on this page:

The overall impact on claim costs depends on the additional cost of screening
and how many insured members get screened relative to how many members
are subsequently diagnosed with conditions that require further treatment.

Page 14

The first paragraph of Core Reading in Section 3.4 has been amended to read:

Investment performance may be of lesser significance when considering private

medical insurance due to its short tail from premium receipt to claim settlement
(typically no longer than 3 to 5 years). For some long-term insurances,
particularly pre-funded long-term care, the investment assumptions and hence
risks may be major considerations.

The following paragraph of Core Reading has been added after Self-Assessment
Question 22.7:

For insurers paying claims in foreign currencies (which is more likely for PMI
business than any other products in the Subject ST1 syllabus), the insurer will
be exposed to exchange rate movements and may need to invest in assets in the
relevant foreign currencies.

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Page 16

The final paragraph of Core Reading has been amended to read:

Risks become wider when third parties are involved and the ultimate expense
costs are difficult to estimate. For example, income protection insurers and PMI
insurers may use third parties to manage their claims. This additional outgo
might be deemed part of the overall claim amount (and loaded as such)
especially if costs vary directly with the amount of benefit.

Chapter 23

Pages 4, 5, 8, 9, 11, 18, 19 and 20

There have been a number of additions to these pages. Replacement pages are attached.

Chapter 25

Page 18

The following paragraph has been added at the end of Section 5.2:

The deposit back arrangement will also serve to mitigate the reinsurer default
risk to which the cedant is exposed.

Page 32

The penultimate paragraph of Core Reading has been amended to read:

The excess point (or attachment point) and upper limit (or exhaustion point) for
stop loss are often expressed as a percentage of the cedant’s premium income
for that account. Cover might typically be given from an excess point of 110%
claims ratio up to an upper limit of 130% or 140%.

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Chapter 27

Page 15

The word “possible” has been deleted from the second sentence of the final paragraph
on this page, ie:

There may be a regulatory requirement to allow for mismatching. This could

involve the setting up of an investment mismatching reserve.

Page 24

The penultimate paragraph of Core Reading has been amended to read:

The method of valuation of assets will depend on the purpose of the exercise
and the market’s perception of fair value. For PMI business, as it has typically
only short-term liabilities, there would be little alternative but to value the
backing assets (normally cash or similar to cash) at their market price.

Chapter 29

The following definitions have been amended:

Affinity group

A group of people with something definitive in common, such as holding a

membership or being an employee of a particular organisation (eg a motoring
organisation such as the RAC in the UK or the armed forces), but not common
employment.

Insurance premium tax (IPT) (UK)

Insurance premiums are exempt from VAT in the UK, but most general insurance
premiums are subject to an insurance premium tax (IPT), currently (May 2016) at
the rate of 9.5%.

So, for example, this tax is levied on PMI premiums.

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3 Changes to the ActEd Course Notes

This section contains additional significant changes to the ActEd Course Notes.
However, if you wish to have all the changes to the ActEd Course Notes, you will need
to buy a full set of the up-to-date version (which you can do at a significantly reduced
price if you have previously bought the full-price Course Notes / CMP in this subject).

Chapter 1

Page 10

The following sentence has been added after the “Over-insurance” heading:

“Benefit payments under an IP policy will generally be subject to an upper limit,

usually defined in terms of a maximum replacement ratio (eg 75%).”

Solution to self-assessment question 1.6

The sentence “The claim strain at risk is very large.” has been replaced by:

“So potentially someone could fall sick shortly after taking out the policy, and remain
sick for many years, costing the insurer considerably more than the assets it has
accumulated on the policy.”

Solution to self-assessment question 1.12

The answer has been amended to read:

“The rating of an occupation depends upon its expected claims experience, so a change
in the rating of teachers (from Class 1 to Class 2 or 3) suggests that insurers have seen a
rise in claims from those in the teaching profession.

The increase in claims is most likely to be a result of the increased pressures of the job.
This has resulted in an increase in stress-related illnesses, such as psychiatric illnesses
and heart attacks.”

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Chapter 3

Page 24

The final paragraph has been amended to read:

“The law in the UK has been changed so that, from April 2015, pensioners are no
longer required to purchase an annuity with any pension savings. This could have
impacts on the long-term care insurance market as older people may have access to a
pot of money with which to purchase long-term care insurance products.”

Solution to self-assessment question 3.16

The answer has been amended to read:

“Capital is required to cover the new business strain, ie the excess of the reserves,
solvency capital and initial expenses over the first premium.

A higher capital requirement will delay the emergence of profit from the product, so
while the level of profit will not be affected, the present value of the profit will be
lower. So, to achieve the required (present) value of profit, the premium will have to be
higher.

Therefore a lower capital requirement will mean that the required profit criterion can be
achieved with lower premiums.”

Chapter 8

Page 34

The solutions to Self-Assessment Questions 8.17 and 8.18 have been amended.
Replacement pages are attached.

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Chapter 10

Page 5

The first paragraph of ActEd text has been updated to read:

An example of a specific health charge in the UK is national insurance (NI), which is a

system whereby earners are taxed an amount on their income in addition to general
income tax. The tax raised in this way is earmarked for spending on State healthcare
services and to pay for State benefits (eg State pensions). Since the early 2000s,
15-20% of the funding for the UK National Health Service has been from NI
contributions.

Chapter 13

Page 18

The following paragraph has been added between the two Core Reading paragraphs in
Section 4.4:

An embedded value considers the present value of future profits from the in-force
business only. However, the company should be able to use its expertise and brand
name to add value to the business through sales of profitable new business in the future
too – and this will be represented by the goodwill element of the purchase price.

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Chapter 14

Page 12

Self-Assessment Question 14.11 has been amended. The revised question and solution
are:

Question 14.11

State how you expect recovery rates to vary in relation to the following factors:

(i) the length of time since the policyholder fell sick

(ii) the length of the deferred period of the policy

(iii) the length of time since claim payments were started.

(i) Duration since the policyholder fell sick

The majority of sickness durations are very short, usually under 6 months in length.
Individuals who are still sick after 6 months will often remain sick for very long periods
of time.

Therefore recovery rates typically decrease with increasing duration since the start of
sickness, reflecting the reducing proportion of the less serious cases remaining (ie the
increasing proportion of serious cases).

(ii) Deferred period

The longer the deferred period, the more likely the policyholder is to recover before the
claim begins. Therefore for very short deferred periods, recovery rates may be
significantly higher than for longer deferred periods.

The length of the deferred period can also affect the type of individual taking out a
policy, affecting recovery rates further. For example, individuals who believe they are
only likely to make claims for longer sickness durations may choose longer deferred
periods. (If they then do tend to suffer from long-duration sicknesses, recovery rates
will be lower.)

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(iii) Duration since the start of claim payments

Similarly to part (i), recovery rates typically decrease with increasing duration since
the start of claim. Therefore recovery rates tend to be higher in the period immediately
after claim payments have started.

This effect will be more pronounced the shorter the deferred period is (as explained
above).

Note that the underlying variable affecting recovery rates is the time since the onset of
sickness (as described in part (i)).

So, provided all other factors (like the type of lives insured) are the same, then the
deferred period should not affect the rate of recovery as at a particular duration since
the start of the illness, however it will affect the rate of recovery from the start of the
claim.

However, all other factors will not typically be the same. For example, the amount of
claims control is likely to be highest early on in a claim. Consider two claimants, both
of whom have been sick for 15 months. One has a deferred period of a year and so has
only been claiming benefits for 3 months while the other has a deferred period of
3 months, so has been claiming benefits for a year. It is likely that the recovery rate for
the policyholder who has only been claiming for 3 months is higher than for the
policyholder who has already been claiming for a year because he/she may have
recently benefited from rehabilitation assistance, such as counselling, (whereas the
longer-term claimant is less likely to have received such assistance recently).

Note also that there might be recovery “spikes”, ie a sudden increase in recoveries at
certain points in time, eg a year after sickness / claim inception. This would be more
pronounced if there is some kind of change at that point in time, eg a fall in benefits or
further claims management (such as the requirement of additional proof of incapacity).

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Chapter 15

Pages 23 and 39

Item (4) has been deleted from Self-Assessment Question 15.18.

Chapter 21

Page 6

The third paragraph has been amended slightly to read:

However, the short-term insurer will need to hold reserves for, amongst other things,
those claims that will arise between the valuation date and the next renewal date. This
is because the insurer will be contractually committed to honour claims that may occur
during this period, and must therefore cover these liabilities sufficiently prudently. The
reserves held to cover this unexpired risk for short-term contracts are called unearned
premium reserve (UPR) and unexpired risk reserve (URR).

Page 26

The second paragraph has been amended slightly to read:

So we calculate the amount of capital we are required to hold in excess of our

market-consistent estimate of the liabilities.

Chapter 26

Pages 25, 27 and 45

ActEd text has been added on these pages. Replacement pages are attached.

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Chapter 27

Page 4

The final paragraph has been amended to read:

It is the most secure asset type, with the least variability in value. It is obviously very
liquid, and dealing costs are almost non-existent. However, the expected return on cash
is relatively low, and an insurer with long-term liabilities will need to reinvest at
unknown rates.

Page 10

There have been a number of small changes to this page. A replacement page is
attached.

Page 34

The solution to Self-Assessment Question 27.14 has been amended. A replacement

page is attached.

Chapter 29

The following ActEd text has been added under the first paragraph of Core Reading in
the definition of “Benefit limitation”:

Benefit payments under an IP policy will be subject to an upper limit, typically

specified in a maximum benefit formula. A major part of the maximum benefit formula
will be a maximum replacement ratio (eg 75%).

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4 Changes to the Q&A Bank

The most significant changes to the Q&A Bank are given below.

Q&A Part 3

Question & Solution 3.14(iii)

The final two points have been deleted from the solution and the number of marks
available has been reduced from [15] to [14].

Q&A Part 4

Four new questions have been added. Replacement pages are attached.

Solution 4.10

The fifth and sixth points have been amended to read:

As the calculation is for statutory purposes, the method should result in a reasonable
estimate of IBNR reserves, which may be prudent. [½]

None of the methods given has an implicit allowance for prudence, and so the methods
and/or assumptions may need to allow for this explicitly, ... [½]

Q&A Part 5

Solution 5.21(i)

The sixth point in the solution has been replaced by:

The moratorium period begins at policy inception and, during this period, the
policyholder must receive no treatment for such conditions in order for subsequent
claims for these conditions to be paid. [½]

However, if the policy does receive treatment for such conditions during this period, the
moratorium period restarts. So, in effect, the policyholder must not receive treatment
for the condition for a continuous period of time that is at least as long as the
moratorium period. [½]

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Q&A Part 6

A new question has been added. Replacement pages are attached.

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5 Changes to the X Assignments

The most significant changes to the X Assignments are given below.

Assignment X1

Solution X1.10

In the section on Benefits, the point beginning “Total claim payments in any policy
year …” has been replaced by:

Limits might apply to claim payments, eg a limit on: [½]

● the total cash paid out in any policy year [½]
● the number of treatments in each policy year [½]
● the proportion of the total medical bill (eg 50%). [½]

In the section on Underwriting, the following point has been added under the first
point:

As the cash benefit is generally small relative to the full cost of indemnity, there is less
financial incentive for potential policyholders to take out a policy if they know they are
to claim shortly. [½]

Assignment X3

Question X3.1 is now X3.2.

Question X3.2 is now X3.1. Part (i) has been deleted and part (ii) has been reduced to
[3] (from [4]).

Question X3.4 has been increased to [9] (from [8]).

Question X3.6 is now X3.8. Part (i) has been increased to [14] (from [12]).

Solution X3.6(i)(c) – the two points after the bullet points have been increased from [¼]
to [½].

Question X3.7 is now X3.6. In part (i), instead of having separate mark allocations for
parts (a), (b) and (c), it is now worth [11] in total.

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Question X3.8 is now X3.7. The product is now referred to as “a new conventional
without-profits medical expense insurance policy” (rather than non-profits).

Assignment X4

Solution X4.8(i)

The two points beginning “The purpose of the arrangement …” and “Limits may apply
…” have been replaced by:

The purpose of the arrangement is to provide a defined cash benefit in the event of a
claim, rather than to indemnify the individual. [½]

As the cash benefit is generally small relative to the full cost of indemnity, there is less
financial incentive for potential policyholders to take out a policy if they know they are
to claim shortly. [½]

Thus it reduces the risk of anti-selection for the insurer. [½]

Limits may apply to ensure that the claim payments to the customer are not more than
say 50% of the medical bill. [½]

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6 Other tuition services

In addition to the CMP you might find the following services helpful with your study.

6.1 Study material

We also offer the following study material in Subject ST1:

● Flashcards
● Revision Notes
● ASET (ActEd Solutions with Exam Technique) and Mini-ASET
● Mock Exam A
● Additional Mock Pack.

For further details on ActEd’s study materials, please refer to the 2017 Student
Brochure, which is available from the ActEd website at www.ActEd.co.uk.

6.2 Tutorials

We offer the following tutorials in Subject ST1:

● 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.

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6.3 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 2017 Student
Brochure, which is available from the ActEd website at www.ActEd.co.uk.

6.4 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 ST1@bpp.com.

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 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.

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ST1-04: Health and care insurance products – PMI and related products Page 7

The product does not cover out-patient episodes and this may be seen as a
serious marketing disadvantage; however the compensation is a significantly
lower premium. One big advantage to the insurer lies in the simplicity of a fixed
benefit schedule that limits the work to be performed at the claims stage.

For example, major medical expenses (MME) has existed in the UK as both:
● a short-term annually renewable product
● a long-term product, albeit with reviewable premiums.

Question 4.4

What are the main differences between the benefits available under the MME policy
described here to those available under a CI policy?

It should be noted that in the USA, the term “major medical expenses” is closer
to the UK “private medical insurance”.

Question 4.5

A recent innovation is a policy that provides partial protection for people deciding
against comprehensive private medical insurance and ready to pay a share of private
treatment costs themselves. Premiums are significantly lower than for conventional
medical insurance. Policyholders handle arrangements with the hospital, negotiate fees
and pay for treatment themselves. They are reimbursed a percentage of fees by cheque
within seven days. There is a choice of three percentage levels of reimbursement: 30%,
50% or 75%.

Out-patient tests and consultations prior to treatment are not covered. Follow-up
out-patient consultations and treatment are covered for 90 days after leaving hospital.

The monthly premiums at age 50 are:

Level of benefit Monthly premium

30% reimbursement £7
50% reimbursement £12
75% reimbursement £17

(i) Describe the features of this policy that you think are attractive to the insurer.
Explain your answers.

(ii) What are the advantages and disadvantages of this policy for the policyholder?

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2.2 Waiting list plans

Another approach to cover limitation in order to reduce premiums is to provide

standard medical insurance benefits in circumstances where the public health
service is not in a position to provide treatment within a specified period (often
six weeks). If the policyholder can find free public healthcare for his or her
condition in that period and within a reasonable radius of residence, the
insurance will not reimburse private expenses; otherwise the policy operates as
a normal comprehensive PMI policy.

This approach supposedly meets the customer needs where the desire to buy
insurance is to avoid waiting for treatment. If the customer’s reasoning is
different, this alternative is unlikely to be attractive.

2.3 Health cash plans

Health cash plans are a defined-benefit defined-premium insurance product. For

premiums as low as €2 or $2 per week, the subscriber and family are entitled to a
range of specific payouts dependent on certain healthcare related events.

These include:
● dental
● optical
● physiotherapy
● maternity
● hospitalisation
● recuperation
● hearing aids
● consultation.

Schedules of benefits are bought in “units” with equivalent levels of contribution

increase.

Limits may also apply to ensure that the claim payments to the customer are not
more than say 50% of the medical bill.

This is a form of coinsurance with the policyholder.

The products are typically community-rated and a waiting period (maybe six
months) often applies before benefit eligibility. Pre-existing conditions may also
impact on ability to claim.

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ST1-04: Health and care insurance products – PMI and related products Page 9

The purpose of the arrangement is to provide a defined cash benefit in the event
of a claim, rather than to indemnify the individual. As the cash benefit is
generally small relative to the full cost of indemnity, there is less financial
incentive for potential policyholders to take out a policy if they know they are to
claim shortly. This reduces the risk of anti-selection for the insurer.

Question 4.6

(i) Explain why it is not feasible to undertake full underwriting on cash plans.

(ii) Describe each of the following conditions and explain their purpose:
(a) a waiting period before a policyholder becomes eligible for benefits
(b) a moratorium on claims related to pre-existing conditions.

As mentioned above, six months is a common waiting period for most benefits.
However, there is normally no waiting period on claims resulting from accidents. For
obvious reasons, the waiting period for payouts on the birth of a child is usually at least
nine months!

Individual rating is the most common form of rating in personal insurance. At the
underwriting stage we collect information about the insured individual, such as their
age, gender and state of health. We then use this individual-level information (provided
legislation permits) to determine the premium rate that the individual will pay.

A community-rating system does not use individual information. It will only use group-
or community-level information, such as where a person lives or their occupation. All
those individuals that belong to a group, having the same values of these
community-rating factors, will be charged the same premium. In effect no individual
proposer that meets the eligibility conditions will be refused insurance, because there is
no underwriting at the individual level.

The common premium charged may increase from year to year as a result of increases
in claims costs. Sometimes, even community-level information will be ignored and the
same premium will be charged to everyone choosing a particular level of benefits.

The product’s profitability is dependent on long-term policyholder loyalty, on

cost-efficient claims admission procedures and on volumes in force.

Question 4.7

Explain why long-term policyholder loyalty and a large volume of in-force policies help
to ensure the success of a portfolio of cash plan policies.

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Question 4.8

(i) Explain how community rating could lead to cross-subsidy between

policyholders.

(ii) Cross-subsidy usually provides an opportunity for policyholders to select against

the insurer. Explain how this might happen.

(iii) In some countries (eg Ireland) a system of lifetime community rating has been
proposed for PMI. This system allows insurers to charge premiums that vary by
age at entry, but which do not change after entry provided the policy is renewed
each year.

Explain how a lifetime community-rating system avoids some of the pitfalls of a

community-rating system.

2.4 Dental plans

While some comprehensive PMI policies include dental insurance, this cover is
obtainable separately. Insurers work closely with dentists to ensure that
applicants are screened initially for pre-existing conditions or imminent
treatment and to ensure that dental intervention thereafter is in accordance with
risk expectation. The two principal methods are:

● the capitation basis – where the insurer and dentist agree a sum per
annum per insured mouth

● the indemnity basis – where the insurer covers the actual cost of
treatment delivered.

Under the capitation basis, the patient pays a regular fee to the insurer who deducts an
amount for its expenses and passes the remainder on to the dentist. In return, the dentist
provides treatment. Therefore, the dentist bears the risk that the cost of treatment
required will be more that expected. The insurer will deal with the administration of the
arrangement, but will often only cover the cost of accident and emergency treatment
(eg where the patient is away from home and unable to visit their own dentist).
Therefore, the patient will be covered for both emergency treatments (by the insurer)
and treatments under normal circumstances (by the dentist).

Under the indemnity basis, the insurer bears the experience risk. This can be on a full
indemnity basis, but often limits, excesses or coinsurance will apply.

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2 Worksite marketing
This is a process whereby a broker or insurer representative obtains permission
from the employer to address the entire workforce and sell health and care
insurance products.

For example, the insurer might be given the opportunity to send mailshots to all of an
employer’s workforce or to advertise in the employer’s staff newsletter.

The complexity of the cover suggested depends on the sophistication of the staff
being targeted, but generally the intention is to offer simple products. The
distributor aims to attract those who have not made their own insurance
provision for healthcare needs and do not have adequate employer-paid cover,
or who perhaps have cover for themselves but not for their dependants.

Question 8.5

Explain the difference between the situation described above and typical
employer-sponsored group health and care insurance products.

This form of distribution is unlikely to be undertaken for LTCI products, but is

already part of the health cash plan and simple PMI product markets. Similarly,
there is scope to sell CI and IP insurances in this way.

Question 8.6

Suggest two reasons why long-term care insurance is unlikely to be sold this way.

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3 Different types of commission

Here we look at the different commission structures that might be in place.

3.1 Initial and renewal commission

Initial and renewal commission is a common remuneration structure for the sale of
long-term healthcare insurance products. It involves two levels of payment: a high
“initial” level, paid for a certain initial period from the start of the policy (eg 24
months), followed by a much lower “renewal” level paid thereafter. The two
commission levels are generally expressed as percentages of the premiums payable
during the same periods. The period over which the initial commission is payable may
vary by product and also within products, eg by policy term.

In a similar way, short-term healthcare products, such as PMI, will often have a higher
rate of commission payable for a policy that has been sold to a client for the first time,
compared with a policy that has been renewed.

Indemnity commission

Indemnity commission is a form of initial commission. It is a lump sum payment

from the insurer to the distributor in respect of new business written. It is
typically expressed as a percentage of the first premium, but may be expressed
as a proportion of sum insured.

By “distributor” we simply mean the intermediary who sells the insurance policy on the
insurer’s behalf.

Payment of indemnity commission indicates that the insurer is willing to pay the
distributor commission in respect of premiums that the insurer has yet to
receive.

Indemnity commission involves the payment of the initial commission immediately

when the policy has been sold. It represents advance remuneration to the intermediary
for premiums that are expected to be paid in the future, as well as for the premium paid
on day one of the policy. It would be calculated as a discounted value of the initial
commission that would otherwise have been paid under the policy.

This will generally involve the insurer in some form of new business strain.

Question 8.7

Why?

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Indemnity commission may be paid to any distributor who needs cash “up-front”
to develop his/her business, eg to support the cost of marketing ahead of commission
from resulting sales.

The insurer will make some form of credit check on the distributor, to satisfy
themselves of the credit-worthiness of the intermediary.

Question 8.8

Why?

This commission style provides a very strong incentive for the salesperson to
sell and tends to produce “hunters”, those that attempt to sell one product only
to a customer, rather than “farmers”, those who believe in the value of a
long-term relationship and building up a stream of recurring commissions.

Intermediaries can be influential in nurturing existing clients, by providing a good

service and building up relationships with them, thereby improving the proportion of
policies that are renewed each year.

On the other hand, a remuneration system that is heavily biased towards rewarding first
sales to new policyholders will encourage intermediaries to seek new clients and as a
result to spend less effort on keeping existing ones.

The insurer’s commission structure is therefore an important aspect of its new business
and marketing strategy.

Question 8.9

Which strategy is better for the insurance company: hunter or farmer?

Clawback arrangements

The adviser earns indemnity commission over a defined period, which is

normally stated in months.

This is known as the earnings period.

If a policy lapses before the commission is fully earned (ie during the earnings
period), then the insurer will clawback the proportion of indemnity commission
that is deemed not to be earned at the point the policy is lapsed.

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This repayment is often called clawback.

The extent of clawback is calculated by a formula specified in the commission

agreement, such as the proportion of the initial commission that the number of
premiums actually paid bears to the number expected during the earnings
period.

If a policy were to lapse after the earnings period, then the insurer would not
require any further clawback.

Example

Earnings period: 24 months.

Initial commission: £60.

Assuming the policy lapses after 9 months, and ignoring any discounting, the clawback
would be:

60 ¥
(24 - 9) = £37.50
24

The commission agreement between insurer and intermediary will specify the precise
rules according to which indemnity commission is deemed to be unearned, and has to
be paid back. Naturally enough, the longer a policy remains in force, the less
commission has to be ultimately repaid.

Renewal commission

Where the commission paid is a large initial amount (such as indemnity

commission for regular premium products), there is often a lesser amount
payable as renewal commission for the balance of the policy term to encourage
the distributor to promote persistency. This may, for example, be paid annually
after the end of the earnings period for contracts paying initial indemnified
commission. For annually renewable contracts, a renewal commission, usually
lower than initial commission, can be paid every time the contract is renewed.

Question 8.10

The initial commission is often a function of the premium-paying term of the policy.
Explain the likely reason for this.

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3.2 Level commission

Level commission is an alternative commission method whereby every premium

paid by the policyholder entitles the distributor to a set proportion of that
premium.

Question 8.11

List the advantages and disadvantages of level commission compared with high initial
and low renewal commission.

Level commission does not involve the insurer in any strain, but takes longer for
the distributor to receive a full reward. It matches commission outgo to premium
contribution and to profitability more appropriately.

3.3 Alternative commission structures

Between level and indemnity commission is the system of initial commission

spread over a limited number of years, eg in the UK this is typically two or four
years.

This is simply the initial and renewal commission structure we described at the
beginning of Section 3.1.

Commission is sometimes paid in proportion to the sum insured in some

territories. This would reflect an insurer’s preference for higher sums at risk
rather than premiums as sources of profit.

This might be appropriate, for example, if an insurer has a strategy of trying to attract
business from younger policyholders, for whom:
per-policy profits are higher on such policies (due to the insurer’s pricing
strategy)
for a given premium, benefits are typically higher (as younger policyholders are
typically less likely to claim).

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There are therefore two main ways in which we can pay commission that reflects the
profitability of the whole contract to an insurer:
level commission paid as a proportion of each premium
high initial commission / low renewal commission, where the initial commission
is related to the total amount of premium payable (eg the amount of annual
premium and the number of annual premiums payable over the policy term).

The potential therefore exists for there to be a lot of variation in commission structures
between insurers, and getting the balance right between initial and renewal
commissions can be a key element of an insurer’s marketing strategy.

However, many of the above structures and formulae will be market norms
established under law by the regulators or accepted as codes of practice by the
insurers under the guidance of industry bodies.

So the variation in structures seen in practice, within markets, tends to be more limited.

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Solution 8.15

Insurance intermediaries are representing the interests of their clients, not a particular
insurance company. The insurance company needs to be aware of the possibility that an
intermediary might encourage anti-selection.

It should also be borne in mind that it is the intermediary or his/her customer who is
“initiating the sale”, which may also increase the risk of anti-selection, compared with,
say, when the customer is targeted by a company salesperson.

Also, insurance intermediaries are more likely to have customers with high net worth
(rich people), with consequent need for higher insurance cover.

Prices will need to be competitive, as intermediaries have access to, and in theory
knowledge of, the whole market. This may only be achievable by careful selection of
good risks through stringent underwriting.

(One factor working against this is that there will be competitive pressures not to make
underwriting too stringent for business sold through intermediaries, for fear of
discouraging business. In other words, if too great a proportion of applicants are
refused acceptance at standard rates by a particular company, the intermediary will stop
recommending that company for most of his/her clients.)

Solution 8.16

Experience would probably be poor. The target population may experience relatively
poor health and the only underwriting is a statement of good health. High risk
individuals would be able to take out the contract, and as a result experience might be
worse than general population morbidity in the first few years, until the effect of this
anti-selection has diminished.

The low benefit in the first twelve months would at least discourage fraudulent claim
attempts by those who are initially seriously ill, although twelve months may not be a
sufficiently long period.

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Solution 8.17

Selling through intermediaries generally requires competitive terms. In particular:

(a) Critical illness premium rates are easily compared for policyholders with
particular ages, policy terms, smoker status and sums insured. However,
products can be differentiated by the cover provided – eg having different
definitions of diseases covered – although the scope may be fairly limited.
(There is likely to be competitive pressure to provide at least as much cover as
the market “norm”, which may further be set out as industry-wide codes of
practice.)

It is very important for an insurance company to have competitive rates if it

wishes to sell large volumes. Companies may increase competitiveness in other
ways, such as by including renewal or conversion options or other kinds of
benefits, but this can only be of limited effectiveness (eg not all policyholders
require these add-ons).

(b) Competitive expense and other charges are important. However, competition
will depend (to some extent) on past investment performance as well as charges.

In addition, if the unit fund is protected, competition on past investment

performance will also be important as this will affect the value of the
policyholder’s fund. Some of the competitive pressure can be avoided by
varying product features, eg different claim definitions, introducing options
and/or guarantees .

Solution 8.18

This is saying that – due to the law of large numbers – a larger number of reasonably
homogeneous lives insured increases the certainty of claims, allowing smaller risk
margins to be included in the rates.

The risk may also be reduced for the following additional reasons:

If a large proportion of an employer’s staff can be sold policies, then the risk of
anti-selection is reduced, reducing expected claim rates.

People at work must be well enough to do the work, and so the condition of
being actively employed will help to ensure the company is dealing with a
largely healthy group of lives (provided, again, that a large proportion of staff
take up policies).

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Chapter 21
Reserves and solvency capital requirements

Syllabus objectives

(l) Describe the purposes of reserves, solvency capital requirements and

embedded value, and the methodologies by which they are calculated for a
health and care insurer, including:
role of statistical and individual case estimates
setting assumptions, including a comparison with those used in pricing
market-consistent valuation
the interplay between the strength of the supervisory reserves and the
level of solvency capital required
Value-at-Risk (VaR) capital assessment
comparison of passive and active valuation approaches.

(The items in bold are covered – or partly covered – in this chapter.)

0 Introduction
This chapter explains why and how health insurers calculate reserves and solvency
capital. If you have already studied Subject CA1, then you will have already met some
of the main methods and reasons for calculating reserves and solvency capital. This
chapter expands on that material and applies it more specifically to health insurers.

Even if you have not seen Subject CA1, the material in this chapter should still make
sense based on your studies of the CT subjects.

To place a value on the liabilities we must use a reserving basis. There are many
possible approaches we could use in practice. Several factors help determine what an
appropriate basis may be in a particular situation, the most important of which is usually
the purpose of the investigation. This chapter is a study of these factors and how they
are applied in different practical situations.

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Changing the reserving basis does not affect the true financial position of the company,
but it usually changes its disclosed result. While using a different valuation basis has no
direct effect on the real situation, there may be indirect effects. For example, if an
over-cautious basis caused an insurer to conclude that its solvency was in doubt, then
the insurer might choose to change investment policy. Thus the true situation would
have been indirectly influenced by the choice of valuation basis.

An insurer’s available capital is the excess of its assets over its liabilities. Regulation is
likely to require insurers to hold solvency capital in addition to its reserves. So to be
solvent, the insurer needs to have available capital in excess of this required capital, ie
its free capital needs to be positive. This is summarised in the diagram below:

Free capital

Available
capital Required
capital
Value of
assets

Value of
liabilities

There are a number of different valuation methods that may be used. The suitability of
each method depends on a number of factors, and different actuaries and regulators have
different views on which factors are the most important. These valuation methods can
be split into two broad groups: passive valuation approaches (where the reserves are
relatively insensitive to market conditions and the assumptions are updated
infrequently) and active valuation approaches (which are based more closely on market
conditions and where the assumptions are updated more frequently).

The topics covered in this chapter are:

the main reasons why health and care insurers calculate reserves (Section 1)
the different types of reserves that may be needed for long- and short-term
business (Section 2)
the two main methods of setting reserves for long- and short-term business
(Section 3)
the need for solvency capital and its calculation (Section 4)
market-consistent reserves (Section 5)
a comparison of active and passive valuation approaches (Section 6).

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6 Active and passive valuation approaches

6.1 Passive valuation approach

A passive valuation approach is one that uses a valuation methodology that is

relatively insensitive to changes in market conditions and a valuation basis that
is updated relatively infrequently.

A change in market conditions can affect both the value of the assets and the value of
the liabilities (eg if the valuation interest rate is derived from the yield available on
assets). However, we will see below that under some valuation methods the value of
the assets and/or the value of the liabilities change very little with market movements.

Under a passive valuation approach, the assumptions for mortality and expense inflation
would rarely change.

An example would be the net premium valuation approach for liabilities (as
described in Subject CT5), which is fairly insensitive to yield changes due to the
net premium also being recalculated under the new assumptions.

Question 21.16

(i) Describe how a net premium valuation would be calculated.

(ii) Explain why the net premium valuation is relatively insensitive to changes in the
valuation interest rate compared to a gross premium valuation.

Under passive approaches, assumptions may be “locked in”. That is, they
remain unchanged from those used when that policy was first written and the
liability for it first determined. It may be a requirement, however, that
non-economic assumptions are updated if experience worsens, in order to
recognise the related loss and the need for higher reserves at that time.

So the same valuation interest rate may be used throughout the term of the policy (ie the
interest rate is locked in). This might be considered acceptable because any increase
(decrease) in interest rates would decrease (increase) both the value of the assets and the
value of the liabilities. If assets are chosen that are well matched to the liabilities the
true solvency of the company will be unaffected by market changes.

However, non-economic assumptions such as morbidity may have to be varied over

time, because if experience deteriorates, the cost of benefits will rise without any
corresponding change in asset values.

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For the valuation of assets, an example of a passive approach would be the use
of historic cost or “book value”, possibly with amortisation (or “write-down”)
over time.

By using a book value approach to valuing assets, we are ignoring the impact of
changes in market prices. This might be suitable if the valuation of liabilities is also
largely ignoring market conditions, eg if the valuation interest rate is locked in or if a
net premium valuation is used.

Solvency capital requirements may be determined using a simplified approach

such as holding a prescribed percentage of best estimate liabilities.

Advantages of using a passive valuation approach

Passive valuation approaches tend to be more straightforward to implement,

involve less subjectivity and (to the extent that they are used for accounting
purposes) result in relatively stable profit emergence.

Disadvantages of using a passive valuation approach

Question 21.17

What do you think is the key disadvantage of a passive valuation approach?

6.2 Active valuation approach

In contrast, an active approach would be based more closely on market

conditions, with the assumptions being updated on a frequent basis.

An example would be the use of market-consistent valuation approaches for

both assets and liabilities, and a risk-based capital approach to solvency capital
requirements.

The market-consistent valuation approach was described in Section 5 and a risk-based

capital approach was described in Section 4.3.

Advantages of using an active valuation approach

Active valuation approaches are more informative in terms of understanding the

impact of market conditions on the ability of the company to meet its obligations,
particularly in relation to financial guarantees and options.

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Disadvantages of using an active valuation approach

However, results are potentially more volatile using an active value approach.
Under adverse equity market conditions (eg a stock market crash), an active
valuation approach using risk-based capital would indicate that higher capital
requirements are needed. In order to reduce this requirement, companies would
need to sell equities – which itself could exacerbate the market conditions.
There is also systemic risk, as this would be the case for all health and care
insurance companies at the same time. Therefore it may be the case that
regulators include amendments to the valuation approaches under such
conditions, to avoid this situation.

This is not just a theoretical risk. This is exactly what happened following the financial
crisis of 2007/2008. As market prices fell (particularly for assets such as corporate
bonds and equities) the solvency of banks and insurers also fell. To protect their
solvency many of these financial institutions sold their risky assets and replaced them
with safer assets such as government bonds. This meant that there was a huge supply of
risky assets but very little demand, and so the market price slumped to a level far less
than what many analysts would have regarded as the true value.

Furthermore, an active valuation approach is likely to be more complex than a passive

approach. So the calculations could take longer to perform and be more costly.

6.3 Combinations

The overall valuation approach may instead be somewhere between the two
extremes, including elements of each.

This can result in a greater mismatch between assets and liabilities, and hence
greater profits/losses or changes in free assets when market conditions change.
For example, an approach that uses a net premium valuation for liabilities and
market value of assets could experience greater volatility of results than one that
uses a market-consistent valuation for both.

Question 21.18

Explain the last sentence above.

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7 Glossary items
Having studied this chapter you should now read the following glossary items:
Asset share
Claims paid, claims incurred
Combined ratio
Earned premium
Incurred but not reported (IBNR)
Loss ratio
Operating ratio
Reported but not settled (RBNS)
Written premiums.

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The aggregated capital requirement combines the separate stress tests to allow for any
diversification benefits that exist between the various risks. This may be done through
the use of correlation matrices or by copulas.

Market-consistent valuation

To determine a market-consistent value of liabilities, future unknown parameter values

and cashflows are set so as to be consistent with market values, where a corresponding
market exists. Market values are also used for assets, if market prices exist.

Future investment returns are based on a risk-free rate of return, irrespective of the type
of asset actually held, and the discount rates are also based on risk-free rates.

Risk-free rates may be based on government bond yields or on swap rates. It may be
appropriate to make a deduction to allow for credit risk.

Under certain conditions, it may be possible to take credit for the illiquidity premium
available on corporate bonds and thereby discount liabilities at a higher yield than the
risk-free rate.

It may be difficult to obtain a “market-consistent” assumption for some elements of the

basis, such as morbidity, persistency or expenses, for which there is not a sufficiently
deep and liquid market in which to trade or hedge such risks.

It is then likely that a risk margin would be added to the best estimate of the liabilities.
This risk margin would reflect the compensation required by the “market” in return for
taking on those uncertain aspects of the liability cashflows.

This could be done by adding a margin to each such assumption or by using the “cost of
capital” approach.

Passive and active valuation approaches

A passive valuation approach is relatively insensitive to changes in market conditions

and has a valuation basis that is updated relatively infrequently.

An active approach is based more closely on market conditions, with the assumptions
being updated on a frequent basis.

Passive approaches tend to be easier to implement, involve less subjectivity and result
in relatively stable profit emergence. Active approaches are more informative in terms
of understanding the impact of market conditions.

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Solution 21.12

The insurance company’s solvency position would improve.

Under the old rules, the insurance company would have to discount its liabilities at the
risk-free rate of 4%.

Under the new rules, the insurance company could add in the illiquidity premium so that
it discounted its liabilities at 5%. The higher the discount rate, the lower the value of
the liabilities, and hence the better the solvency position.

Solution 21.13

This is because the benefit cashflows are not of certain amounts, but are instead
dependent upon how many (and precisely which) of the current policyholders survive to
each future date. In other words, the cashflows are subject to uncertainty due to
mortality.

Solution 21.14

Using best-estimate mortality assumptions would produce a value that was lower than
the market-consistent value. This is because a purchaser of the liability would require
additional compensation, for the possibility that the liability should turn out to be more
expensive than expected.

Solution 21.15

We should assume lower mortality, as it is greater longevity that will increase the cost
of these liabilities to our notional purchaser.

Solution 21.16

(i) Calculation using a net premium valuation approach

A net premium valuation is a method for placing a value on a health and care insurer’s
liabilities that involves calculating a present value of the contractual liabilities and
deducting the present value of future net premiums.

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More specifically:
the contractual liabilities allow for the benefits only
the net premium is calculated on the basis of the valuation assumptions and is an
amount that will provide the contractual benefits offered at the commencement
of the policy; it is not the actual premium paid (ie the gross or office premium).

The key point to note here is that the calculation allows only for mortality / morbidity
and interest, ie it ignores expenses.

(ii) Why the net premium valuation approach is relatively insensitive to changes in
the valuation interest rate

For a gross premium valuation, if the valuation interest rate decreases, then the present
value of both the benefits and the premiums would increase (although the level of the
gross premium would remain unchanged). However, the impact would be greatest for
the benefits because they are paid later than the premiums and so are discounted for
longer. So we would expect the reserve to increase for a gross premium valuation
(assuming the reserve was positive).

For a net premium valuation, however, we would also need to recalculate the net
premium using the new valuation interest rate. A decrease in the interest rate would
increase the net premium, so the present value of the premiums would increase by more
under a net premium valuation approach, and the increase in premiums would be closer
to the increase in the benefits. So for a net premium valuation the impact of a change in
the valuation interest rate is less than for a gross premium valuation.

Solution 21.17

A passive valuation is at risk, by its very definition, of becoming out of date. It is

relatively insensitive to changes in market conditions and has a valuation basis that is
updated relatively infrequently.

For example, if the stock market crashes then the book value of the assets will be
overvalued relative to their value if sold in the market today. Similarly, the net
premium valuation is relatively insensitive to changes in interest rates (as described
in the solution to Question 21.16.

If the valuation basis is changed infrequently then it may not have taken account of
important trends, eg rising expense inflation or deteriorating claims experience.

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So there is a danger that a passive valuation approach provides a false sense of security.
Management may fail to take appropriate actions in response to emerging problems
until too late, because the solvency position hasn’t appeared to change.

Solution 21.18

If the assets and liabilities are well matched, then the true impact of market movements
on the company’s solvency should also be quite small. Under an active valuation
approach, any change in the value of the assets should be reflected in a corresponding
change in the value of the liabilities (eg if interest rates fall then both valuations should
rise), so the solvency position should be little changed. Under a passive valuation
approach, the value of the assets and liabilities might be little changed by market
conditions, so again the solvency position should be little changed.

However, if a combination of active and passive approaches is used then solvency

might appear to change dramatically (when in reality it hasn’t changed). A change in
interest rates would change the market price of assets, but would have little impact on
the net premium valuation of liabilities.

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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.

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ST1-23: Nature of risks (2) Page 3

The model would be run using simulations. This could produce several thousand
possible values for the unit fund at retirement, and hence of the cost of the guarantee,
derived from the investment returns generated by the model. An estimate of the
expected value of the cost of the guarantee would then be an average of all the
simulated outcomes.

The estimate of the cost of the guarantee might then be used to work out the charge to
be levied for the guarantee on the policy. This can itself cause more problems! You
can end up going round in circles because the more you charge for the guarantee, the
more money is taken out of the unit fund, making the guarantee more onerous and
increasing its cost!

The results will only be valid if the model and the chosen parameters are appropriate.
Either might be inappropriate, in which case the company might charge too little or too
much.

It is also worth mentioning that the insurance company could greatly reduce the risk it
faces from the guarantee if it could protect itself with a suitable derivative.

Health and care events are often less easy to predict than their life insurance
counterparts and greater care has to be taken in the wording of options and
guarantees, the prices charged for them and the reserves held to provide for
their utilisation. The measurement of the risk will vary directly with the relevance
and volume of data used to assess its impact.

This extra uncertainty could be reflected in our models created above. For example,
extra prudence could be built into the parameters used.

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2 Competition
The need to compete, in a free market, may lead the management of an insurance
company to take decisions that increase its risk profile beyond that which can be
supported by the available resources. Some of the decisions that it might take are:

● reduce premium rates or charges under new business contracts

● offer additional guarantees and options under new business contracts

● increase the coverage under existing contracts, eg further critical

illnesses

● increase salaries or commissions in the respective distribution channels

● on existing business with reviewable charges, constrain the future growth

of charges.

The impact of the above decisions can then be compounded if greater volumes of
new business result.

Equally, the actions of competitors can have adverse implications for new
business volumes and for the renewal of short-term health insurance policies.
For example, cheaper cover could be offered by competitors, which could result
in policyholders selectively lapsing their policies.

Question 23.2

A health insurance company has decided to add a renewal option to its ten-year
without-profits critical illness contracts. It will charge for this option by increasing the
premium for the original contract to cover the expected cost of the option. Has the risk
for the company increased by giving this option?

It is of course not always the case that the example decisions given in the Core Reading
above will be inappropriate or will stretch an insurance company beyond its means.
Where this is the case, the actuary’s course of action will depend on local regulation
and professional guidance, and on the actuary’s professional conscience.

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3 Actions of management
An actuary of a health and care insurance company will make recommendations
as to how it should operate so that its risk profile stays within the resources
available to it. However, management may choose not to follow these
recommendations:

● for competitive reasons as mentioned in the previous section

● due to strategic company goals, such as maximising new business

volumes or amount of funds under management (including differentiating
by market segment and allowing cross-subsidies)

● so as to maximise shareholder earnings.

There is nothing in itself wrong with seeking to maximise shareholders’ (expected,

risk-adjusted) returns. However, the actuary may be in a particularly good position to
judge the financial risks involved in a particular course of action.

The actuary may also have a regulatory or professional responsibility to ensure that
inappropriate risks are not taken, particularly where the security and fair treatment of
policyholders are concerned.

There may in fact be a fundamental conflict between shareholders’ interests and those
of policyholders, because the two groups may have very different attitudes to the
trade-off between expected profit and risk of insolvency. For example, a without-
profits policyholder has nothing to gain from the insurance company pursuing high
profits at high risk, but a great deal to lose if the result is insolvency.

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4 Counterparties
When an insurer enters into an agreement with another entity, it is relying on that
entity to meet its obligations under the agreement. There is a risk that the entity
will not be able to do this, and that it may either fully or partially default on its
obligations or perform them to an unacceptable standard; this is counterparty
risk. The term “credit risk” may also be used to describe counterparty default
risk.

The use of counterparties can also increase other types of risk due to the
reduction in direct control, eg greater operational risks.

4.1 Reinsurance arrangements

When an insurance company enters into a reinsurance agreement with either

another insurance company or a pure reinsurance company, there is a risk that the
reinsuring company will fail to meet its obligations, eg it may default on the
payment of reinsurance claim recoveries.

We shall be discussing reinsurance more fully later in the course. Reinsurance is a

process by which part of the liability under a contract, and hence some of the risk, is
passed on to another insurer.

Such an insurer may specialise in reinsurance business and not write any business
directly to the public (a “pure reinsurance company”). Alternatively, the reinsuring
company may just be another insurance company (although this is rare for health and
care insurance).

The usual contractual arrangement is that the full liability to the policyholder rests with
the insurance company that sold the business in the first place. The reinsurer’s liability
is to the insurance company, not to the policyholder. If the reinsurer is unable, perhaps
because of financial difficulties, to pay its share of a reinsured claim, then the insurance
company faces a greater cost than expected.

The possibility of such a failure therefore represents a risk for the insurance company.

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4.2 Distribution

The risks here are that:

● A distributor may be in a position, knowingly or otherwise, to commit the

insurer to conditions that were not the original purpose of the contract.

For example, a broker might (if allowed), in the course of selling a long-term
care insurance contract, manually change the policy wording by making the
ADLs more lenient, in order to satisfy a demanding customer.

● A distributor, under circumstances where policyholder money

transactions are conveyed through the distributor, may not return
premiums received at the appropriate time, or may become bankrupt
before these are passed over (ie credit risk). A similar problem may arise
with claims.

For example, the broker might hold on to all premiums paid to him and only
pass these on to the insurer at the end of every quarter. These represent very
short-term assets to the insurer, but have the added complication of possible
default.

At the other end of the spectrum, a valid claim payment may be made by the
insurer to the broker, to be paid in due course to the policyholder. It is possible
that the broker becomes bankrupt before the claim payment is finally made, in
which case the insurer will probably still be liable.

● A distributor may, in dealing with clients on behalf of the insurer, bring

the insurer into disrepute.

For example, the broker might dispute a claim directly with the policyholder,
only for the policyholder to find out later from the insurer, after complaining
directly to it, that the claim was perfectly valid.

The nature of the practical and legal relationship between the insurer and the
distributor will dictate the extent of these risks and the means to mitigate or
resolve their impact.

For example, thorough training and established claim control procedures should
mitigate the example in the third risk above.

We will cover risk mitigation in more detail in Chapters 25 and 26.

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4.3 Provision of medical services

The area of health and care insurance is a complex one and often third parties
are involved to manage aspects of the client relationship and control claims
cost. Examples of these are underwriting agencies, third party claims assessors
and disability counsellors. The extent to which these bodies can commit
expenditure on behalf of the insurer is a source of risk.

Under medical expenses covers and some long-term care insurances, the benefit
itself is provided by third parties on an indemnity basis. The risk of the ultimate
claims cost then lies, to at least some extent, in the hands of these third party
providers. Insurers may have some control or influence over these third parties
(eg agreements with medical providers).

Question 23.3

What do you think could be done to mitigate the risk of using third parties for claim
handling?

4.4 Investment

There is counterparty risk associated with some investments that the insurer
may be holding to back its business. This particularly relates to corporate bonds
and deposits. There is a risk that the issuer of the bond (or holder of the
deposit) will default on its obligations to pay coupons (or interest) and/or to
repay the debt (or deposit).

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5 Other sources of risk

5.1 Legal, regulatory and tax developments

Local law and supervisory requirements may often over-ride the explicit
conditions specified in the policy. New legislation and regulation may apply to
policies already in force, changing the nature of the contract between insurer
and policyholder. For example, certain exclusions may be deemed no longer
acceptable or the payout for certain conditions may be increased nationally by
court precedent. Taxes may be introduced to benefits or premiums that may
change the profitability or coverage of existing contracts.

Another example of a legal restriction is the prohibition of certain factors to be taken

into account when pricing policies. For example, in some countries, local legislation
prohibits the use of race as a factor to be used to determine critical illness insurance
premium rates.

Long-term care insurance is another type of health insurance that is likely to be the
target for legal developments. It is an unwritten rule (in most developed countries at
least) that “Society” should take care of the sick and elderly. So, often these contracts
are subject to unexpected and sudden mandatory changes, even for in-force policies.

There’s not a lot that can be done about this. The best plan is to keep an ear to the
ground to listen out for any possible developments, and build a certain level of prudence
into your assumptions just in case.

5.2 Reputation

Where there is a high degree of consumer market awareness or culture of

consumer protection, the insurer runs a risk of losing both existing client base
and potential new business, as a result of obtaining a reputation for poor
customer service. This may arise formally and legally through the courts and
regulators, but also less formally through press comment, television exposure
(consumer watchdog programmes), word of mouth and, increasingly, through
social media.

Again, the media generally like to concentrate on insurance “misdemeanours”,

especially where these occur against the sick or elderly. Therefore, health and care
insurers often have a moral obligation over and above their contractual policy
obligations, sometimes arising quite unexpectedly.

As noted in Section 4.2 above, there is also a reputational risk relating to

counterparties used for distribution.

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5.3 Internal audit failures / fraud

Any business operation is at risk from internal misdemeanour or fraud, which is

a type of operational risk. Staff in positions of trust may abuse that privilege.
This may take the form of leaking of confidential information or the
embezzlement of funds. Appropriate training, governance and internal audit
procedures are vital.

Over the last few years in the UK (and these years are not exceptions) you will have
undoubtedly seen press articles about possible fraudulent internal corporate activity, not
only within health and care insurers but in any corporation.

5.4 Physical risks

An insurer runs a number of risks to the physical conduct of its business, eg fire,
flood, loss of key staff. It is imperative to have business continuation
procedures in hand to manage the smooth flow of business in these
circumstances, including systems back-ups and alternative premises. Insurance
cover will be needed after the event, including business interruption cover, but
the intervening damage makes proper processes and drills essential.

5.5 Aggregation and concentration of risk

Part of an insurer’s assessment of portfolio risk will be the extent to which the
insurer is over-exposed to a particular risk or region as a result of specialisation
of product or concentration of distribution. Examples of this in health and care
insurance might arise where a small sickness insurer was at risk of an outbreak
of local illness, or where an insurer had concentrated on providing group income
protection to a particular industry that was now associated with a particular
disease.

These risks are mitigated through more widespread marketing, through

reinsurance and through coinsurance with reciprocation.

Coinsurance with reciprocation is whereby risks are shared with another similar insurer
(or reinsurer), but one having risks of a complementary nature. For example, the “small
sickness insurer” above, is at risk of an outbreak of local illness, could share its risks
with another (perhaps small) sickness insurer with a concentration of risks in another
area of the country. By sharing each other’s risks, diversification is achieved for both
insurers.

You will meet more on reinsurance and coinsurance later in the course.

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5.6 Catastrophes

A health and care insurer is at risk from a catastrophe, ie an event that gives rise
to the introduction of widespread illness (eg epidemic, pandemic) or injury
(eg war, terrorism). By their very nature, these are difficult to predict. Their
resolution lies mainly in reinsurance or possibly in more global expansion to
spread the risks.

Furthermore, policy terms and conditions may be written to specifically exclude

claims relating to risks caused by such events.

A catastrophe in health and care insurance is normally an event that gives rise to many
individual claims, all stemming from the same cause (such as an epidemic or war).
You would not normally get an individual immense loss. This fact will influence the
type of reinsurance that an insurer would buy.

5.7 Non-disclosure and anti-selection

We introduced underwriting in Chapter 7. It is covered in detail in Chapter 26.

Non-disclosure, the decision made by the policyholder at the proposal stage not
to share all risk-related information with the insurer, is difficult to police and
prove. It makes the assessment of appropriate premiums more problematic.

The problem is possibly exacerbated if the insurer decides to accept all

policyholders initially on the basis of a declaration of health and then underwrite
more formally at the claim stage – the moratorium approach (see Chapter 26).
Here the insurer will have greater difficulty in proving knowledge at the time of
policy application and in many territories it is often a cause of media outcry if
claims are refused at a time of medical need.

Question 23.4

So why go for the moratorium approach at all?

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Resolution or mitigation can be achieved through:

● clearly explained sales literature
● effective sales intermediary processes
● clearly worded proposal forms
● more frequent use of doctors’ reports at new business stage
● more checking of information provided
● thorough audits on sample cases
● closer dialogue between underwriting, sales and claims management.

The topic of access to information from genetic tests is very relevant here and
may be subject to local legislation and practice.

The use of genetic test results was introduced in Chapter 9.

Anti-selection (and its management) has been discussed elsewhere in the

course. The key risk to the insurer is a greater degree of anti-selection than has
been anticipated in the premium rates, emphasising the important link between
pricing and underwriting.

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A financial risk from lapses will also arise at times when the asset share is
negative.

The capital requirements of a stand-alone contract or the marginal requirements

of a rider benefit will be of the same order as for an income protection contract.

This is likely to be the case because expenses and commission for the contracts will be
of the same order and the supervisory requirements should be similar.

6.3 Long-term care insurance risks

The main risk with such contracts relates to the transition probabilities in the
underlying multiple-state model. Of these the most important will be the claim
inception probabilities and any transition probabilities between claim states if
there are more than one. Associated with these, there will be a significant
anti-selection risk and a risk from selective withdrawals.

With long-term care contracts we may well assume that there is no equivalent of the
“sick to healthy” transition we saw for sickness contracts, although this cannot be ruled
out. However, there may be several claim states that the claimant may go through, with
different benefits payable in each. For example, there may be at least one level of home
care and at least one level of residential care.

A typical multiple state model might be the following:

States:
1. healthy
2. needing own-home care
3. needing residential home care
4. needing nursing home care
5. withdrawn
6. dead.

Transitions:
1. separate transitions from healthy to each of the other states
2. separate transitions from [2 to 3], [2 to 4], and [3 to 4]
3. separate transitions from each sick state (2, 3 and 4) to dead.

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Features to note are that there should be the same number of sick states as there are
categories of benefit level, and that while there are transitions between all sick states
they are normally only in the one direction: that of deteriorating health and higher claim
cost. (This assumes that people normally only deteriorate with age. Reverse transitions
could be included between the sick states if this were felt to be appropriate to the lives
in question. Ignoring the reverse transitions is also the more prudent assumption.)

The problem of moral hazard would be unmanageable without the use of ADLs, which
were discussed earlier in the course.

In most markets there is currently a shortage of reliable data on which to base estimates
of transfer probabilities, because the contracts are relatively new. The contracts are
relatively well established in the United States, but US data may need significant
adjustment before it could be used in other countries.

Question 23.12

Explain why this would be the case.

There will be an investment risk as significant reserves may build up in advance

of a claim starting, and there will be an expense risk.

Question 23.13

Explain why the reserves could be quite large despite the fact that this is a pure
protection policy.

At times when the asset share is negative, there is a financial risk from
withdrawal. At other times, whether there is such a risk depends on how any
withdrawal benefit paid compares with the asset share.

There are additional risks where the policy pays directly to the care provider and
where the policy indemnifies the cost of care.

If the policy pays directly to the care provider, then there is a risk that a payment is
made upfront, and then the care provider subsequently goes bankrupt. If the policy
indemnifies the cost of care, then there is a risk that care costs are higher than expected,
perhaps due to higher than expected care cost inflation.

There could be a significant marketing (and reputational) risk with these

contracts, as the policyholder may expect the benefits to be enough to cover the
eventual costs of care.

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With most benefit definitions, the company would not be guaranteeing to cover the total
cost of care, and so would have to be careful to make this clear to the policyholder. If
the policyholder was led to an inappropriate expectation that all care costs would be
covered, then a failure to meet the expectation would do the company’s public image no
favours, and would almost certainly be bad for future sales of the contract.

Question 23.14

What is the problem with using a benefit definition of the “cost of care needed”?

The capital requirements could be comparable to those for endowment

assurance, or other types of investment contracts, but will depend on the nature
of the contract and in particular any guarantees that are given.

An endowment assurance is a contract of fixed term, that pays a benefit on maturity or

on earlier death. The benefits may be linked or non-linked, and may have guarantees.

The similarity to the endowment as regards capital requirements stems from the fact
that a long-term care contract has the same pattern of paying regular premiums in
advance, for a benefit that (when payable) will be paid from the point at which
premiums stop.

It can perhaps be considered as even more similar to a whole life assurance (where the
benefit is paid on death whenever that might be), as there is no fixed latest time at
which the claim has to be paid. But unlike an endowment or a whole life assurance, the
benefit under a long-term care policy is not certainly paid, as policyholders can die
without needing any long-term care.

With guarantees come risks, and increased risk is likely to require increased prudence
and hence larger reserves (or larger solvency capital). Some supervisory authorities
may specifically require additional reserves / capital to be established to cover certain
types of guarantee.

6.4 Private medical insurance risks

The main risk to the insurer is that it may have limited control over the benefit
payments. An anaesthetist or consultant will make their own decisions
regarding what they charge for services rendered – although the insurer can
impose some constraints through the use of agreed fee schedules and hospital
lists. The insurer may also have some ability to influence the insured members
to its preferred medical providers with whom it has agreements.

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Similarly, the original trigger for the claim may be the general practitioner
referring the patient for specialist advice, so claim frequency is very much bound
up in this process of referral – over which the insurer has no direct control.

The risk of anti-selection is an issue for individual business and small groups,
with the insurer typically mitigating this risk by performing medical underwriting
at the policy inception. However, this can still be a risk for health service
requirements that can be planned to some extent (eg pregnancy, dental and
optical services).

In regions where the State offers an alternative (free) healthcare service, the
insurer is constantly under pressure to remind policyholders that the insurance
package is preferable to the “free alternative”. Failure to do this, especially in
difficult economic times (and thus when premiums become unaffordable for many),
may result in the loss of considerable business, with associated risks of inability
to cover expenses and ultimate insolvency.

However, it is interesting to note that most PMI insurers still give cash benefits for
using the alternative free health and care service for some treatments, even though their
insurance would normally cover the cost of treatment. This keeps claims costs down, as
the cash benefit will be less than the cost of providing the treatment and for many
treatments the policyholder may not care whether he or she received private or State
treatment (eg for emergency, but minor treatment, such as a minor fracture).

While most claims are modest in comparison with many commercial general
insurance risks, the private medical insurer is always at risk, where no policy
limits apply, of a single large claim (eg expensive treatment in the USA) or a
single incident giving rise to an accumulation of claims (eg accident within a
single insured workforce).

However, most PMI policies do specify policy limits for most types of claim.

Capital strain under PMI is not usually as severe as under many of the long-term
products.

This is because of its short-term nature. Reserves need only be held in respect of a
one-year time horizon, and so the possibility of something going horribly wrong is
much reduced (although of course the insurer would hope to keep the policy in force for
much longer than one year).

Significant new business cost can, however, arise in scenarios where an insurer
decides to invest in the recruitment of an existing sales team and either a
“golden hello” is payable or initial commission is promised that exceeds an
annual premium.

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This new business cost would arise whatever the contract type. Hopefully, the insurer
will allow for this extra cost in its business model, to ensure that overall, profits will
ultimately meet required targets. Clearly the idea of enhanced commission is to
encourage sales and so it is hoped that the profit on the greater volumes of business
would pay (at least) for the extra commission.

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

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6 Service level agreements with outsourcers

6.1 General points

Techniques for managing counterparty risk include:

through due diligence on the counterparty before selection

Due diligence involves an investigation of the counterparty prior to signing a

contract. Performing such investigations should enable the insurer to make an
informed decision about whether the counterparty meets the required standards.

diversification across different counterparties

By using several counterparties, the insurer will reduce the risk of default / poor
performance by any single counterparty. If you have studied Subject CA1, you
may remember that insurers should diversify by provider of reinsurance and this
point generalises this idea to any counterparties the insurer uses.

Note that the insurer may be limited in its ability to diversify in certain
circumstances, for example, if it is small or if there is only a limited number of
possible counterparties.

single counterparty exposure limits

This is similar to the point above about reducing the risk of default / poor
performance by any single counterparty.

restriction on the use of counterparties below a specified credit rating

This should help to ensure that counterparties meet certain standards. It may be
a quicker, simpler way of ascertaining the quality of outsourcers without
carrying out a full due diligence investigation.

credit insurance or derivatives.

Credit insurance is a type of general insurance that should protect the insurer
against the risk of default, insolvency or bankruptcy of the counterparty. A
credit derivative may be used to transfer the risk of counterparty default to a
third party.

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6.2 Use of outsourcing

In many territories of the world, third party specialists have been developed to
assist the insurer in several core areas of business processes. The third party
salesperson has been around for a long time and is characterised by the
insurance intermediary or broker. Equally companies have been set up that will
perform other specialist activities: underwriting, claims management, actuarial
functions (for example, pricing and reserving), administration, investment,
marketing, systems and training.

The key offering is that the third party provides a level of expertise and efficiency
at a price that may be cheaper than in-house costs, and leaves the insurer’s
management to perform the other tasks where they feel most competent,
including, of course, the strategic decisions.

6.3 Service level agreements

Once the third party is chosen, a service level agreement will be put in place.

This will be a legal contract, and is often known as an SLA (Service Level Agreement).
The SLA should contain precise details of the role that each party agrees to undertake
(very much like a reinsurance treaty). The details depend on what each party agrees and
is prepared to accept, but often problems involving third parties are due to imprecise or
ambiguous SLAs.

In return for fees (unit costs or periodic payments), certain tasks will be
performed to a pre-specified standard and within pre-specified times. The
insurer should be confident that by passing certain processes in the business
chain to experts, the insurer is reducing risks. However, since the tasks are
being performed by third parties, the insurer will need to have regular reports,
checks and inspections in order to ensure that the insurer is not to suffer from
reputational risks, business risks and security issues. Timely resolution or
correction of any issues will also be required.

For example, a third party performing the underwriting function on behalf of an insurer
will need to report on, and meet certain required targets in respect of:
time taken to underwrite cases
the proportion of cases accepted, declined and rated
the quality of customer satisfaction.

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Question 26.17

What areas should be covered in a contract between an insurer and a third party
provider of services?

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7 Other internal processes

7.1 Enterprise risk management

Enterprise risk management (ERM) is a risk management framework that

considers the risks of the business as a whole, rather than considering
individual risks in isolation. This allows the concentration of risk arising from a
variety of sources within an organisation to be appreciated, and for the
diversifying effects of risks to be allowed for. This is the holistic, integrated
approach to risk management.

You may have read about enterprise risk management in earlier subjects, such as
Subject CA1.

An insurer needs to be aware of, and assess, the overall risk profile to which it is
exposed, based on an aggregation of the underlying risks that it faces, allowing
for correlating effects.

Note that correlations may have both positive and negative effects. Positive correlations
between risks will typically act to increase the risk, whereas negative correlations will
typically act to reduce the risk.

Question 26.17a
Give an example of correlated risks that might reduce the overall risk to an insurer
selling an IP insurance contract.

The role of the actuary in managing an insurer’s risks should therefore be a

regular programme of advising the directors of the nature and size of the risks
faced. Particular attention will need to be given to those risks that are the most
material and/or the most sensitive to change.

Risks should be controlled by analysing and explaining their nature, costing

them as far as possible, and agreeing on management strategies for them. In the
case of sensitive risks, the actuary should model a range of long-term scenarios
to show the impact of variations to future experience, and management
strategies should be designed to protect against those risks that the insurer is
able to (and chooses to) control.

Once risk management strategies have been agreed, they should be documented
and implemented. Where the strategies consist of objective rules and
procedures, these should then be monitored on an ongoing basis.

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If you have studied Subject CA1, you will be familiar with the process of managing
risks, which involves:
identifying risks
measuring risks
controlling risks
financing risks
monitoring risks.

Question 26.18

How does this risk management process apply to the role of the actuary here?

Strong governance and controls are vital to an insurer’s risk management

framework.

Another element of ERM is the recognition that value can be added to a business
through educated risk-taking, with a strong risk management framework that
better allows companies to identify and assess strategic opportunities.

7.2 Experience monitoring and control

As part of the actuarial control cycle, the actuary will periodically review the experience
of the company’s own portfolio of health and care insurance business.

The periodic review of an insurer’s experience (including claims, expenses and

distribution, and analysis of surplus) is considered in more detail in Chapter 28.

Such analyses can help the insurer to identify the appropriate risk management
actions, such as described elsewhere in this chapter (and Chapter 25) or other
actions such as:
expense controls
policy retention activity
reviewing new business strategy
asset-liability management
capital management.

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7.3 Data analytics and predictive modelling

Relating to the above section, health and care insurers are able to take
advantage of technical developments in the analysis of large volumes of data
(“big data”).

In general, big data is a broad term for data sets that are so large or complex that
traditional data processing applications are inadequate.

Increasingly large quantities of data are being recorded about us every day: the things
we buy, the places we go, the websites we visit. As computers get ever faster, it is
possible to analyse these data to look for patterns and predict future behaviour. For
example, some internet stores are incredibly good at predicting the goods and services
people want and sending personalised adverts for just the right thing.

For example, bancassurers hold a large quantity of information about a customer

who also has a bank account with them, including data on that customer’s
spending habits. The ability to analyse and use such information to understand
better the underlying risks will become increasingly important in insurance, as
more sophisticated analytical techniques develop to facilitate this.

The bank can analyse spending patterns on current accounts or credit cards to look for
behaviour associated with low morbidity rates (eg subscriptions to a gym) or high
morbidity rates (eg purchases of potholing equipment). The bank can then pass this
information to its insurance operation.

Insurance companies that are not part of a bank could access other sources of data. For
example, supermarkets collect large quantities of information through their loyalty card
schemes – customers that buy lots of fresh fruit might have lower morbidity rates than
customers that buy lots of cream buns.

Question 26.19

How might big data be used by insurers?

Risk classifications are likely to develop as a result, allowing more accurate

rating for each individual customer. The insurer also then has greater ability to
select the preferred risks.

Traditionally, health and care insurance has been rated on factors such as age, gender,
occupation and location, and then making generalisations that all the people within a
particular rating cell will act in the same way. In the future, health and care insurance
may be rated on factors that directly affect morbidity such as diet and exercise.

© IFE: 2017 Examinations The Actuarial Education Company

 ST1-26: Other risk management techniques Page 31a

Monitoring the available data may also allow the insurer to drive better
experience, through early identification of changes in individual insured risks or
potentially through being able to intervene and influence customer behaviours.

For example, if a customer’s records showed a decline in the purchase of fruit and
vegetables then the insurer could send out advice on healthy eating.

Multi-factor predictive modelling techniques (eg using generalised linear models)

are also increasingly being adopted. These techniques can combine the
internally held customer data with external drivers, allowing for correlations and
interactions between them.

We’ve described some of the advantages of big data above, but there are also risks.

Question 26.20

What risks are there for an insurance company that uses “big data”?

7.4 Quality of staff

The successful performance of a business is down in large measure to the

quality of the staff employed and their exercise of judgement. Thus there needs
to be in place adequate systems of identification of competence levels required
at the various stages of business administration, of recruitment, of staff training,
allocation and review and of recognition of the need for outside expertise.
Motivation and reward are other key features here.

These systems need to monitor for fraudulent as well as incompetent behaviour.

Health care insurers have to be particularly careful about the competence of their staff.
This is because there is far more opportunity for fraud and judgement in health care
insurance than in, say, life insurance. That is because, in life insurance, the benefits are
generally paid on death. It takes an extreme scenario to generate a false claim here,
although that’s not to say it doesn’t happen! A typical claims underwriting process in
life insurance is simply to have proof of death (eg death certificate).

In health insurance, however, there is more scope for fraud, since claims can be
exaggerated or falsified more readily. We have all seen cases on television where
someone who is claiming IP benefit and is meant to be sick off work, is filmed surfing
on holiday!

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Question 26.21
List areas of competence or expertise in risk control that will be needed by a health and
care insurer.

Companies may perform an occasional audit of staff competence. “Time and

motions” analysis by independent experts may also indicate the need for staff
reallocation and training.

You may have been involved in a time and motion study at work if you have been asked
to record exactly what tasks you have carried out, and how much time was spent on
each one, over a period of time. The results can indicate who does what in a company
and for how long. Hence, it can be the first stage in identifying where improvements
can be made, but the results do depend on the accuracy of the information recorded.

© IFE: 2017 Examinations The Actuarial Education Company

ST1-26: Other risk management techniques Page 45

Solution 26.14

The company will probably still be holding quite high reserves for this policy, reflecting
the high expected claim costs over the final five years of the policy relative to the (now
relatively small) remaining premiums to be paid. All else being equal, therefore, the
company would be better off if the policy were to lapse, as the reserve would be
released into surplus (instead of being needed to pay claims).

However, all is not likely to be equal. In particular, it is more likely that the
policyholder who lapses is in good health rather than in poor health. This is particularly
the case here, as the premiums being paid here are far lower than could now be obtained
by taking out a new policy for the remaining five years of cover, so anyone with a
feasible chance of claiming would be likely to keep their policies in force. As a result
of this selection, the company would have been likely to have made a profit from the
policy, if it had continued in force (by paying five more years’ worth of premiums and
not claiming), and so the company is likely to be worse off as a result of the lapse.

Solution 26.15

Poor or ambiguous policy wording can result in disgruntled policyholders, at a time

when they need financial assistance for deteriorating health. In the interests of customer
satisfaction and public relations, it may be beneficial for an insurer to pay the claim
even though strictly speaking it does not have to. Indeed the courts, or supervisory
authorities (such as the financial ombudsman in the UK), may rule that such claims
should be paid, particularly if it can be proved that customer expectations were that such
claims would be paid. In some cases, the insurer may decide to settle claims out of
court, thus avoiding any adverse publicity and/or legal expenses.

Solution 26.16

An embedded value is the expected present value of future profits on existing business.
Usually, the value of any net assets attributable to shareholders is also included in the
embedded value.

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Solution 26.17

The contract agreement or SLA should include details of:

dates for which the agreement is in force
who the parties are, who the main contacts are, who is going to carry out the
work and who the ultimate responsibility lies with
what the third party will provide, including to what level and at what frequency
payments to be made to the third party (amounts, frequency, methods, any
conditions, etc)
any other obligations on the insurer’s part
how, and how often, the standard of service will be monitored
what action will be taken if service standards are failed (eg penalties)
cancellation agreements (get-out clauses).

Solution 26.17a

Improvements in healthcare and medical advances might:

reduce claim inception rates
increase longevity.

Therefore claim inception rates and longevity are likely to be negatively correlated.

Reduced claim inception rates will be a good thing for the insurer as there will be fewer
IP claims. Increased longevity may be a bad thing for the insurer as claims could last
longer. Therefore the combination of reduced claim inception rates and increased
longevity should be less bad for the insurer than just increased longevity.

Solution 26.18

Risk identification

The actuary should start by identifying the risks to which the business is exposed.

Particular consideration will need to be given to those risks that are the most material
and/or the most sensitive to change.

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ST1-26: Other risk management techniques Page 47

Risk measurement

Next, the actuary should consider the nature and size of the risks identified, and this
should be reported back to the directors at regular intervals.

Risk control

The actuary should consider the different options for controlling the risks, bearing in
mind their nature, and should identify the possible management strategies for them.

In the case of sensitive risks, the actuary should model a range of long-term scenarios to
show the impact of variations to future experience, and management strategies should
be designed to protect against those risks that the insurer is able to (and chooses to)
control.

Risk financing

Next, the actuary should cost the risks and their possible management strategies as far
as possible, and hence agree on the optimal management strategies for them.

Risk monitoring

Once risk management strategies have been agreed, they should be documented and
implemented. Where the strategies consist of objective rules and procedures, these
should then be monitored on an ongoing basis.

Solution 26.19

Big data may be used to:

improve risk classification for individual risks and hence offer more appropriate
terms to applicants
improve the monitoring process and hence take appropriate action, eg by
spotting issues that would otherwise have been missed or by spotting trends
sooner
aid prediction, eg through generalized linear models.

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Solution 26.20

There is considerable potential for reputational damage, eg concerns over privacy and
data protection failures. Policyholders may also find any extra attention intrusive,
eg they may not welcome receiving a message saying “you didn’t buy enough fruit this
month”. As a result, sales might fall and lapses might rise.

As the use of big data develops, the regulations governing it might change, eg the
regulator may require that certain types of data are not used. There could be fines for
any misuse of the data.

The data collected may be inaccurate, incomplete or irrelevant, eg the insurer will not
know whether fruit bought at the supermarket has actually been eaten, or if it has been
bought for cash (and consumed) from other locations, eg from a market stall.

Whenever complex models are used there is the risk of choosing the wrong model.

The expenses of collecting and analysing the data may outweigh the benefits of the
extra information received.

Solution 26.21

The main area is in claims assessment and management:

initial assessment of validity of a claim, including collection of the required
evidence
assessment of suitable treatment process
knowledge of likely inflationary pressures on health claims costs
knowledge of medical procedures available
ongoing assessment and management of the claim (for IP insurance, LTCI,
PMI).

In addition, expertise will be required in the initial underwriting of policies.

© IFE: 2017 Examinations The Actuarial Education Company

 ST1-27: Investment Page 9

Question 27.6

Valuing at an interest rate of 9%, estimate the discounted mean terms of the following:

(a) a new ten year bond with an annual in-arrears coupon of 6%

(b) an equity whose dividends increase at 3% annually

(c) cash

(d) a ten-year single premium critical illness contract (immediately after sale),
assuming a constant claim incidence rate of c = 0.0015 pa for policyholders
surviving to the end of each year, and a constant death rate of q = 0.001 pa.

Currency

Liabilities denominated in a particular currency should be matched by assets in

the same currency, so as to reduce any currency risk.

An alternative way of matching is to invest in overseas assets and then to hedge the
currency risk by use of appropriate currency options.

Question 27.7

Why might a company want to invest overseas?

3.2 Effects of the nature of liabilities

We now consider in further detail the investment implications of the four liability types
defined above:
guaranteed in monetary terms
guaranteed in terms of an index
indemnity
investment-linked.

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Page 10 ST1-27: Investment

Guaranteed in monetary terms

A company will ideally want to invest so as to ensure that it can meet the
guarantees. This means investing in assets that produce a flow of asset
proceeds to match the liability outgo. This will involve taking into account also
the term of the liability outgo, and hence the probability of the payments being
made, so as to indicate the term of the corresponding assets.

This form of liability applies to, for example, conventional critical illness policies. For
these, premiums and benefits are fixed. With large numbers of policies, the cashflows
from premiums and benefits (including expenses) will be statistically predictable. So
the company could try to invest in assets that have an equal (but opposite) cashflow.

Except for certain types of company it will probably be impossible in practice to

find assets whose proceeds exactly match the expected liability outgo. In
particular, the terms of available fixed-interest securities are often much shorter
than the corresponding liabilities. A best match is all that can normally be hoped
for.

In addition to the problem that appropriate assets with a long enough term may not
exist, it might be the case that for a block of recently written business, premium income
may exceed benefits and claims for some years, giving a net cash inflow in such years.
No asset type can match that (at least not without considering investing in derivatives),
and so the company will have to invest these surplus premiums at unknown future rates.

Furthermore, the proceeds from assets may exceed the net liability outgo. The excess
will have to be reinvested at unknown rates, making strict matching impossible. This
problem can be overcome by the use of zero-coupon bonds, but they might not exist in
the market being considered.

The technique of immunisation, covered in Subjects CT1 and CA1, may be used
for this purpose. However that technique is subject to theoretical and practical
problems. A technically superior (though more complicated) approach to
assessing a possible best match will be given in Section 4 below.

Immunisation is an alternative (really a second best) to exact matching. The aim is the
same as that of matching: ie to protect the investor from changes in future interest rates.

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ST1-27: Investment Page 33

Solution 27.12

An insurance company may want to dedicate only a portion of free assets to support the
investment strategy of the policyholders’ fund. This is because the shareholders may
not want to use all of their assets as “security” for that fund: deliberately mis-matching
the policyholders’ fund to increase return, and using free assets as a cushion, means that
those free assets might disappear to pay for any loss arising from the mis-match. Quite
reasonably, the shareholders may not think that increasing the return on assets for the
benefit of policyholders justifies the risk of all of their free assets disappearing.

Another more prosaic reason is that some of the free assets might be inadmissible under
local statute as assets to cover reserves (or any statutory solvency capital requirement).

Solution 27.13

First and most obviously, there is the issue of modelling risk. The conclusions of the
asset-liability modelling process will only be valid to the extent that the model, and the
inherent parameterisation, are valid.

Secondly, there is the issue of considering only a portion of free assets. Although the
owners of the free assets might justifiably not want all of those assets to be put at risk in
supporting an unmatched investment strategy, that does not imply that the model should
necessarily exclude certain assets. For example, we can still have a constraint along the
lines of “we accept that 50% of free assets will disappear with a probability of 1%” but
model the entire asset portfolio, and interpret the results accordingly. This could give
more useful results.

Thirdly, we will need to be very careful if the statutory solvency capital requirement is
not constant. In fact it is commonly defined in many countries as a function of,
amongst other things, the reserves. In this case an approach that is less vulnerable to
error would be to include the solvency capital requirement in the asset-liability model to
ensure that it is modelled correctly.

In other words, a better approach might be for the model to be of the whole company
but possibly with some free assets earmarked “not for solvency demonstration”.

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Solution 27.14

The following will make an investment strategy riskier (interpreting risk as “variability
of profit”):

For assets backing some given liabilities:

– reduce the amount of matching by nature
– reduce the amount of matching by term
– reduce the amount of matching by currency.

And looking at assets in isolation (ie assuming there are no associated

liabilities):
– increase duration.

And in both cases:

– move from government bonds to corporate bonds
– move from AAA-rated corporate bonds down to something lower
– for equities, move from an established company to a new company, or
from an established sector to a new sector.

Note that a company would never normally choose to increase risk without the
possibility of a higher return (and so a higher profit). For example, it might choose to
hold inherently more risky assets (for which there is a higher expected return), or
mismatch its liabilities (again, opening up the possibility of increasing return), but
would not choose to reduce diversification as this is a risk it could reduce without
affecting expected return.

Solution 27.15

The matching requirements may have suggested that a longer-term approach, such as
investing in equities and property, would normally be appropriate. However, even if the
nature of the liabilities have not changed in terms of term or underlying risk, the need
for ready cash may mean that shorter-term investments would be a better idea.

© IFE: 2017 Examinations The Actuarial Education Company

 ST1: Q&A Bank Part 4 – Questions Page 1

Part 4 – Questions

1 Development Questions
Question 4.1

A health and care insurer is using a market-consistent approach to set its reserves.

(i) State when a risk margin might be applied. [2]

(ii) State what such a risk margin should reflect. [1]

(iii) State two alternative methods for applying a risk margin. [1]

(iv) Give a formula for an overall risk margin, defining all terms you use. [2]
[Total 6]

Question 4.2

A health and care insurer sells level immediate needs annuities.

It has the choice of the following assets to invest in:

● a large issue of low grade, short-term, fixed-interest corporate bonds, issued by a

large domestic multinational company

● a small issue of high grade, short-term, fixed-interest corporate bonds, issued by

a small, private local company

● short-term, fixed-interest government bonds.

The corporate bonds provide a similar expected yield, which is significantly higher than
the government bond yield.

(i) Which bonds would be most appropriate to back the annuity liabilities? [6]

(ii) How would the choice of bonds affect the discount rate used to value the
liabilities in a market-consistent valuation? [4]
[Total 10]

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Question 4.3

A health insurance company sells accelerated CI insurance contracts with term of three
years. Premiums are payable annually in advance. The sum insured of 50,000 is
payable at the end of the year that a claim occurs.

The pricing basis uses the following best estimate assumptions:

Claim rate: 0.1% per annum
Interest: 3% per annum
Expenses: initial: 70 incurred at outset
renewal: 5 incurred when second and third premiums are received
claim: 80 incurred when the benefit is paid
Profit loading: 30

Note that the cost of capital associated with the solvency requirements has been ignored
in the pricing calculation for simplicity.

(i) Show that the premium for this policy is 86.26. [3]

The regulator believes that the following assumptions would represent a prudent
estimate of future experience:
Claim rate: 0.13% per annum
Interest: 2% per annum
Expenses: renewal: 6 incurred when second and third premiums are received
claim: 90 incurred when the benefit is paid

The regulator is prepared to allow companies to calculate reserves on a best estimate

basis if they hold additional solvency capital calculated as 0.091% of the sum at risk.

(ii) The contract has just been sold, the premium has been paid and the initial
expenses have been incurred. Calculate:
(a) the change in the assets
(b) the supervisory reserves calculated on the best estimate basis used in
pricing (assuming there is no solvency capital requirement)
(c) the supervisory reserves calculated on the regulator’s prudent basis
(assuming there is no solvency capital requirement)
(d) the sum of the supervisory reserves calculated on the best estimate basis
and the solvency capital requirement. [9]

(iii) Comment on the results of your calculations above. [3]

[Total 15]

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 ST1: Q&A Bank Part 4 – Questions Page 3

2 Exam-style Questions
Question 4.4

A health and care insurer sells stand-alone critical illness business.

Discuss the relative merits of using a passive valuation approach. [6]

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ST1: Q&A Bank Part 4 – Solutions Page 1

Part 4 – Solutions

Solution 4.1

(i) Situation in which a risk margin may be applied to a basis

A risk margin may be applied where it is difficult to obtain market-consistent

assumptions for some elements of the basis, … [½]

… such as morbidity, persistency or expenses. [½]

This is because there is not a sufficiently deep and liquid market in which to trade or
hedge such risks. [½]

In other words, there is not a market big enough so that large trades would not
materially affect the prices. [½]

In such cases, a risk margin would be included in respect of such assumptions … [½]

… due to the inherent uncertainty. [½]

[Maximum 2]

(ii) What a risk margin should reflect

The risk margin should reflect the compensation required by the “market” in return for
taking on those uncertain aspects of the liability cashflows. [1]

(iii) Two methods for applying a risk margin

1. A margin could be added to each assumption for which there is inherent

uncertainty. [½]
2. An overall reserving margin could be determined using the “cost of capital”
approach. [½]
[Total 1]

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Page 2 ST1: Q&A Bank Part 4 – Solutions

(iv) Formula for an overall risk margin

kt ¥ Ct
Risk margin = Â [½]
t (1 + rt )
t

where: kt is the cost of capital “charge” for time t [½]

Ct is the required capital at time t [½]
rt is the risk-free interest rate for maturity t. [½]
[Total 2]

Solution 4.2

(i) Appropriate matching bonds

The annuities are level, and all three of the bonds are fixed interest, so they all provide a
good match by nature. [½]

Immediate needs annuities are generally short-term (typically a few years), … [½]

… so all three of the bonds should be broadly appropriate by term. [½]

The yield margin between the government and corporate bonds reflects the higher risk
of default … [½]

… and lower liquidity of the corporate bonds. [½]

The government bonds should have the lowest risk of default, … [½]

… so these may be the preferred option, especially if the insurer is risk-averse. [½]

The low grade bonds have the highest risk of default, … [½]

… so these may be deemed inappropriate. [½]

The high grade bonds should have a more acceptable level of default risk, … [½]

… and the greater return provided by corporate bonds may make these appealing
enough to choose over the government bonds. [½]

If the insurer has matched its assets and liabilities, then it would not be expecting to sell
the bonds before maturity, and so liquidity is not an essential feature of the assets. [½]

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ST1: Q&A Bank Part 4 – Solutions Page 3

The government bonds should be the most marketable / liquid. [½]

The large issue of low grade company bonds should also be fairly marketable / liquid.
[½]

However, the small issue of small, private company bonds are likely to be considerably
less marketable / liquid, … [½]

… and so a significant part of their yield will be to compensate for this illiquidity. [½]

As liquidity is a feature that is probably not needed by this insurer, these bonds may
therefore be appropriate, … [½]

… as the insurer will be able to benefit from the higher yield without taking on a
significant level of risk. [½]
[Maximum 6]

(ii) How the choice of bonds would affect the discount rate used for the liabilities

In a market-consistent valuation, the discount rate would usually be the risk-free rate
obtainable on government bonds regardless of the choice of assets. [½]

However, an illiquidity premium can sometimes be included in the discount rate used
for the liabilities to take credit for the illiquidity premium in the yield on the assets held.
[½]

A higher discount rate will lead to a lower value of the liabilities, … [½]

… and so a better solvency position. [½]

If the insurer has chosen to hold the government bonds, it will not be able to include an
illiquidity premium in its discount rate. [½]

If the insurer has chosen to hold either of the corporate bonds, then it may be able to
include an illiquidity premium, … [½]

… if this is permitted by regulation / legislation. [½]

It is only generally appropriate to include an illiquidity premium for long-term,

predictable liabilities … [½]

… which will be the case here if the insurer has a large enough portfolio to remove
random fluctuations from the experience. [½]

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Page 4 ST1: Q&A Bank Part 4 – Solutions

The corporate bonds have similar yields overall, however, they are made up quite
differently: [½]

● the multinational company’s bonds have a high risk of default, but are very
marketable / liquid, … [½]

… so the majority of the yield margin (above the government bond yield) will
reflect the default risk [½]

● the small private company’s bonds have a lower risk of default, but are very
unmarketable / illiquid, … [½]

… so the majority of the yield margin (above the government bond yield) will
reflect the illiquidity risk. [½]

Therefore, if the insurer held the multinational company’s bonds, then the scope for
including an illiquidity premium would be small, … [½]

… whereas if the insurer held the small private company’s bonds, then a significant
allowance may be made in the discount rate for illiquidity. [½]
[Maximum 4]

Solution 4.3

(i) Premium

We calculate the premium P by equating the expected present value of the premiums
with the expected present value of the claims, expenses and profit loading.

( ) (
P 1 + 0.999v + 0.9992 v 2 = 50, 080 ¥ 0.001 v + 0.999v 2 + 0.9992 v3 )
( )
+70 + 5 0.999v + 0.9992 v 2 + 30 @ 3%

2.91061 P = 141.51804 + 79.55307 + 30

P = 86.26
[3]

Note that the question has made no reference to lapses, so we have ignored them here
(although in practice, an allowance for lapses would be made).

© IFE: 2017 Examinations The Actuarial Education Company

ST1: Q&A Bank Part 4 – Solutions Page 5

(ii)(a) Increase in the assets

The premium of 86.26 has just been received and the expenses of 70 have just been paid
(assuming that the actual expense experience was the same as the best estimate). So the
assets increase by 16.26. [1]

Note that we would often have a negative asset share at the outset of the policy.

(ii)(b) Supervisory reserve (best estimate basis)

(
V = 50, 080 ¥ 0.001 v + 0.999v 2 + 0.9992 v3 )
( ) (
+5 0.999v + 0.9992 v 2 - P 0.999v + 0.9992 v 2 ) @ 3%

V = 141.51804 + 9.55307 - 164.80961

V = -13.74
[3]

Note that the reserve is negative as is often the case when calculating a best estimate
reserve for a critical illness contract.

(ii)(c) Supervisory reserve (prudent basis)

(
V = 50, 090 ¥ 0.0013 v + 0.9987v 2 + 0.9987 2 v3 )
( ) (
+6 0.9987v + 0.9987 2 v 2 - P 0.9987v + 0.9987 2 v 2 ) @ 2%

V = 187.54903 + 11.62673 - 167.15368

V = 32.02
[3]

Note that the reserve is positive as is usually the case when calculating a prudent
reserve.

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Page 6 ST1: Q&A Bank Part 4 – Solutions

(ii)(d) Supervisory reserve (best estimate basis) plus solvency capital

The best estimate reserves are - 13.74 as calculated earlier.

The solvency capital requirement is:

SCR = 0.00091(50, 000 - ( -13.74))

SCR = 45.51
[1]

So the total solvency requirement is 31.77 (45.51 - 13.74). [1]

(iii) Comments on results

When the company writes this policy its assets increase by 16.26 and its reserves
decrease by 13.74 if we use best estimate assumptions. [½]

So the surplus of the company (assets over liabilities) increases by 30 due to writing
this policy. So if we calculate reserves on a best estimate basis (perhaps for accounting
or internal management purposes) we can see that a profit of 30 occurs at outset (which
is exactly the profit we priced for). [½]

However, the situation is quite different if we calculate reserves on a prudent basis.

When the company writes this policy its assets increase by 16.26 and its reserves
increase by 32.02. [½]

So the surplus of the company (assets over liabilities) decreases by 15.76 due to writing
this policy. [½]

The company now has new business strain, ie the premium of 86.26 is not enough to
cover the initial reserves of 32.02 and the initial expenses of 70. [½]

The total solvency requirement is approximately 32 under both the prudent reserving
approach and the best estimate plus solvency capital approach. So both approaches give
the same level of protection to the policyholders (they both require that the company
sets aside an extra 45.5 over and above the best estimate cost of paying the liabilities)
and have the same new business strain. [1]
[Maximum 3]

Note that the question was designed so that the two prudent approaches gave the same
result!

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ST1: Q&A Bank Part 4 – Solutions Page 7

Solution 4.4

Compared to active valuation approaches, passive valuation approaches:

+ tend to be more straightforward to implement [½]

+ tend to involve less subjectivity, … [½]

… eg a net premium valuation is relatively insensitive to the choice of valuation

basis [½]

+ tend to result in relatively stable emergence of accounting profit [½]

+ may be less likely to be subject to procyclicality and systemic risk: [½]

● a passive valuation of assets (such as historic book value) would be little

affected by volatile asset prices [½]

● an active approach (such as market value) may result in the need to sell
risky assets after a fall in prices, which could lead to further price falls
[½]

– are at risk of becoming out of date, … [½]

… and hence management might fail to take appropriate actions in time; … [½]

… in particular, they might fail to take account of important trends, … [½]

… such as increasing claim incidence rates due to earlier diagnoses of certain

illnesses … [½]

… or increasing inflation of regular expenses and claims expenses [½]

– may provide a false sense of security when the reality is that market conditions
have changed significantly [½]

– tend to be less informative in terms of understanding the impact of market

conditions on the ability of the company to meet its obligations ... [½]

… particularly in relation to financial guarantees and options … [½]

… although it is unlikely that a CI insurance policy would include any financial

options and guarantees, ... [½]

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Page 8 ST1: Q&A Bank Part 4 – Solutions

… and it is unlikely to be exposed to the equity market … [½]

… although it may be exposed to price volatility if it holds corporate bonds. [½]

[Maximum 6]

© IFE: 2017 Examinations The Actuarial Education Company

 ST1: Q&A Bank Part 6 – Questions Page 1

Part 6 – Questions

1 Exam-style Questions
Question 6.1

A health and care insurer sells immediate needs annuities that increase in line with an
index of prices. It believes that the best matching assets are index-linked bonds with a
range of terms up to six years.

(i) Outline the factors that affect whether the insurer would mismatch its assets and
liabilities. [7]

(ii) Describe what is meant by an “illiquidity premium” and discuss whether it is

appropriate to allow for an illiquidity premium in the discount rate to value the
liabilities. [6]
[Total 13]

The Actuarial Education Company © IFE: 2017 Examinations

 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.

© IFE: 2017 Examinations The Actuarial Education Company

ST1: Q&A Bank Part 6 – Solutions Page 1

Part 6 – Solutions

Solution 6.1

(i) Factors that affect the extent of mismatching

The insurer will be forced to mismatch its liabilities: [½]

● as the term of the annuities is not known with certainty [½]
● if index-linked bonds of the right duration do not exist / are not available [½]
● if the index-linked bonds available are not linked to the same price index [½]
● if there is a lag in the index used for the bonds [½]
● if regulation specifies:
– certain assets that the insurer is required to hold [½]
– certain bonds that the insurer is not permitted to hold. [½]

In addition, the insurer may choose to mismatch its liabilities if: [½]
● it has a sufficient level of free assets [½]
● regulation does not prevent mismatching, eg: [½]
– by currency [½]
– by imposing onerous requirements to hold mismatching reserves [½]
● this does not lead to excessive solvency capital requirements [½]
● the proposed alternative assets:
– are available [½]
– provide a sufficiently high expected return to justify the extra risk taken
[½]
– are sufficiently liquid [½]
– do not need a level of expertise above that of the insurer [½]
– do not have prohibitively high dealing expenses or high taxes [½]
● its attitude to risk permits such a strategy, which may depend on: [½]
– the risk management tools it has in place, eg reinsurance [½]
– its need for diversification. [½]
[Maximum 7]

The Actuarial Education Company © IFE: 2017 Examinations

Page 2 ST1: Q&A Bank Part 6 – Solutions

(ii) Illiquidity premium and the appropriateness of allowing for an illiquidity

premium in the discount rate

Illiquidity premium

An illiquidity premium can sometimes be included in the discount rate used to value the
liabilities to take credit for the illiquidity premium in the yield on the assets held. [½]

A higher discount rate will lead to a lower value of the liabilities, … [½]

… and so a better solvency position. [½]

Corporate bonds typically have a higher yield than risk-free (eg government) bonds, …
[½]

… where this reflects both the greater default risk … [½]

… and the relative illiquidity of such assets. [½]

The latter of these contributes the illiquidity premium to the yield. [½]

Appropriateness of allowing an illiquidity premium in the discount rate

The insurer would only be able to include an illiquidity premium to the extent that it
holds corporate bonds to back its liabilities. [½]

If index-linked corporate bonds do not exist or are not available, then it would not be
possible to include an illiquidity premium. [½]

Equally, if the insurer deems that the default risk of holding corporate bonds is too
great, then an illiquidity premium will not be an option. [½]

Assuming that corporate bonds are held, it is only generally appropriate to include an
illiquidity premium for long-term, predictable liabilities … [½]

… for which matching assets can be held to maturity. [½]

Provided the insurer has a large enough portfolio of liabilities so that the term is broadly
known, … [½]

… then the liabilities may be predictable enough to justify the inclusion of an illiquidity
premium ... [½]

© IFE: 2017 Examinations The Actuarial Education Company

ST1: Q&A Bank Part 6 – Solutions Page 3

… as the insurer can hold the bonds to maturity so will not be exposed to changes in
their spread. [½]

However, the term of the liabilities (up to six years) is probably not long enough to
justify the use of the approach, ... [½]

… because the choice of the discount rate has little impact when discounting over a short
period. [½]

Overall, whether an illiquidity premium can be included is likely to be dictated by the

regulatory regime in place, … [½]

… which would also specify how and when it can be used. [½]
[Maximum 6]

The Actuarial Education Company © IFE: 2017 Examinations

 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.

© IFE: 2017 Examinations The Actuarial Education Company

ST1: CMP Upgrade 2017/18 Page 1

Subject ST1
CMP Upgrade 2017/18

CMP Upgrade

This CMP Upgrade lists the changes to the Syllabus objectives, Core Reading and the
ActEd material since last year that might realistically affect your chance of success in
the exam. It is produced so that you can manually amend your 2017 CMP to make it
suitable for study for the 2018 exams. It includes replacement pages and additional
pages where appropriate. Alternatively, you can buy a full set of up-to-date Course
Notes / CMP at a significantly reduced price if you have previously bought the full-
price Course Notes / CMP in this subject. Please see our 2018 Student Brochure for
more details.

This CMP Upgrade contains:

all significant changes to the Syllabus objectives and Core Reading.

additional changes to the ActEd Course Notes, Question and Answer Bank and
Series X Assignments that will make them suitable for study for the 2018 exams.

The Actuarial Education Company © IFE: 2018 Examinations

 Page 2 ST1: CMP Upgrade 2017/18

1 Changes to the Syllabus objectives

There have been no changes to the Syllabus objectives for 2018.

© IFE: 2018 Examinations The Actuarial Education Company

 ST1: CMP Upgrade 2017/18 Page 3

2 Changes to the Core Reading and ActEd material

This section contains all the non-trivial changes to the Core Reading and ActEd text.

Chapter 2

Page 12

The Core Reading in the first sentence of the sixth paragraph on this page has been
amended to read:

The word “total” in the definition in practice usually means the failure of ability
to perform a major or substantial part of the job or function.

Chapter 21

Page 7

The bullet point on this page has been amended to read:

● Unexpired risk reserve (URR) – reserve in respect of the above unexpired

insurance premium where it is felt that the premium basis is inadequate to
meet future claims and expenses.

Page 18

The third paragraph of ActEd material on this page has been amended to read:

The concept of non-separability refers to situations when if two events happen together,
the combined impact is worse than if they had happened separately. For example,
consider longevity risk and expense risk for immediate needs annuities. If
policyholders live longer than expected and per policy expenses are higher than
expected, there is an additional combined impact due to having these higher than
expected expenses payable for longer than expected. If you considered the two risk
factors separately, you wouldn’t be allowing for this additional combined effect.

The Actuarial Education Company © IFE: 2018 Examinations

Page 4 ST1: CMP Upgrade 2017/18

Chapter 23

Page 18

The following sentence has been added to the final paragraph of ActEd material on this
page:

A payment to the care provider could also increase the risk of fraudulent claims being
made, or care needs being over-stated by the provider in order to increase the payments
received.

Chapter 29

The definition of Insurance Premium Tax (IPT) has been amended to read:

Insurance premiums are exempt from VAT in the UK, but most general insurance
premiums are subject to an insurance premium tax (IPT), currently (May 2017) at
the rate of 10.0%.

Note IPT is increasing to 12% from June 2017. So, for example, this tax is levied on
PMI premiums.

© IFE: 2018 Examinations The Actuarial Education Company

 ST1: CMP Upgrade 2017/18 Page 5

3 Changes to the Q&A Bank

All changes to the Q&A Bank are given below.

Q&A Part 4

Solution 4.8(ii)

The sixth point in the solution has been amended in line with a change to the Core
Reading to read:

The URR is the total reserve in respect of the unexpired cover, and will be greater than
the UPR if premiums are inadequate to meet future claims and expenses. [½]

Q&A Part 5

Question and Solution 5.15

All dates in this question have been updated by 10 years, so 2005 becomes 2015, 2006
becomes 2016 and so on.

This change has also been reflected in the solution.

The Actuarial Education Company © IFE: 2018 Examinations

 Page 6 ST1: CMP Upgrade 2017/18

4 Changes to the X Assignments

There have been no changes to the X Assignments for 2018.

© IFE: 2018 Examinations The Actuarial Education Company

 ST1: CMP Upgrade 2017/18 Page 7

5 Other tuition services

In addition to the CMP you might find the following services helpful with your study.

5.1 Study material

We also offer the following study material in Subject ST1:

● Flashcards
● Revision Notes
● ASET (ActEd Solutions with Exam Technique) and Mini-ASET
● Mock Exam A
● Additional Mock Pack.

For further details on ActEd’s study materials, please refer to the 2018 Student
Brochure, which is available from the ActEd website at www.ActEd.co.uk.

5.2 Tutorials

We offer the following tutorials in Subject ST1:

● 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.

The Actuarial Education Company © IFE: 2018 Examinations

 Page 8 ST1: CMP Upgrade 2017/18

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 2018 Student
Brochure, which is available from the ActEd website at www.ActEd.co.uk.

5.4 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 ST1@bpp.com.

© IFE: 2018 Examinations The Actuarial Education Company

SP1: CMP Upgrade 2018/19 Page 1

CMP Upgrade 2018/19

Subject SP1

CMP Upgrade
This CMP Upgrade lists the changes to the Syllabus objectives, Core Reading and the ActEd
material since last year that might realistically affect your chance of success in the exam. It is
produced so that you can manually amend your 2018 CMP to make it suitable for study for the
2019 exams. It includes replacement pages and additional pages where appropriate.
Alternatively, you can buy a full set of up-to-date Course Notes / CMP at a significantly reduced
price if you have previously bought the full-price Course Notes / CMP in this subject. Please see
our 2019 Student Brochure for more details.

This CMP Upgrade contains:

all significant changes to the Syllabus objectives and Core Reading.
additional changes to the ActEd Course Notes and Series X Assignments that will make them
suitable for study for the 2019 exams.

Note that the format of the Course Notes has changed for the 2019 exams. As well as
presentational changes:
the self-assessment questions now contain solutions within the chapters themselves
there are no Q&A Banks; instead, each chapter contains a number of Practice Questions at
the end.

The Actuarial Education Company © IFE: 2019 Examinations

 Page 2 SP1: CMP Upgrade 2018/19

1 Changes to the Syllabus objectives

General changes
The format of the Syllabus objectives has changed. They now include:

Weightings

Weightings that are indicative of the approximate balance of the assessment of this subject
between the main syllabus topics, averaged over a number of examination sessions. For Subject
SP1 these weightings are as follows:

1. Health and Care products and general business environment (15%)

2. Product design and specific features (25%)
3. Risks and risk management (30%)
4. Models and valuation (15%)
5. Monitoring experience and setting assumptions (15%)

Numbering

The numbering of the syllabus objectives has also changed.

Specific changes
Most of the Subject SP1 syllabus objectives have minor changes. In addition, a ‘Solving problems’
objective has been added. The syllabus objectives for Subject SP1 are copied in below:

© IFE: 2019 Examinations The Actuarial Education Company

SP1: CMP Upgrade 2018/19 Page 3

Syllabus
The Syllabus for Subject SP1 is given here. To the right of each objective are the chapter numbers
in which the objective is covered in the ActEd course.

Aim

The aim of the Health and Care Principles subject is to instil in successful candidates the ability to
apply, in simple situations, the main principles of actuarial planning and control that are relevant
to the provision of health and care benefits.

Competences

On successful completion of this subject, a student will be able to:

1. understand the main principles and techniques of actuarial management and control that
are relevant to health and care insurance
2. apply these principles to simple situations within the context of health and care insurance
3. analyse hypothetical scenarios, including using judgement to assess the implications of
possible actions and to develop appropriate proposals or recommendations relating to
the management of health and care insurance business.

Syllabus topics

1. Health and Care products and general business environment (15%)

2. Product design and specific features (25%)
3. Risks and risk management (30%)
4. Models and valuation (15%)
5. Monitoring experience and setting assumptions (15%)

The weightings are indicative of the approximate balance of the assessment of this subject
between the main syllabus topics, averaged over a number of examination sessions.

The weightings also have a correspondence with the amount of learning material underlying each
syllabus topic. However, this will also reflect aspects such as:
the relative complexity of each topic, and hence the amount of explanation and support
required for it
the need to provide thorough foundation understanding on which to build the other
objectives
the extent of prior knowledge which is expected
the degree to which each topic area is more knowledge or application based.

The Actuarial Education Company © IFE: 2019 Examinations

Page 4 SP1: CMP Upgrade 2018/19

Detailed syllabus objectives

0. Introduction

0.1 Define the principal terms used in health and care. (Chapter 31)

1. Health and Care products and general business environment (15%)

1.1 Describe the main types of Health and Care contract and their purpose for the
customer: (Chapters 1 to 5)

critical illness insurance

income protection insurance
long-term care insurance
health cash plans
major medical expenses
private medical insurance
group and individual covers.

1.2 Understand the operating environments in which health and care insurance
products and services are traded: (Chapters 8 and 9)

distribution channels
regulatory and taxation regimes
professional guidance
economic and political influences.

1.3 Explain the role of the State in the provision of alternative or complementary
health and care protection: (Chapter 10)

objectives of State healthcare provision

methods of State healthcare provision
funding approaches.

2. Product design and specific features (25%)

2.1 Demonstrate an understanding of health and care product design, including:

(Chapters 6 and 7)

2.1.1 Describe the principles by which health and care insurance contracts are designed
and the interest of the various stakeholders in the process.

2.1.2 Determine a suitable design for a product in a given situation.

2.1.3 Discuss the relative merits of different product designs.

© IFE: 2019 Examinations The Actuarial Education Company

SP1: CMP Upgrade 2018/19 Page 5

3. Risks and risk management (30%)

3.1 Assess how the following can be a source of risk to a health and care insurance
company: (Chapters 23 to 25)

data
claim rates
claim amounts
investment performance
expenses and inflation
persistency
mix of new business
volume of new business
guarantees and options
competition
actions of management
actions of distributors
counterparties
legal, regulatory and tax developments
reputation
internal audit failures/fraud
physical risks
aggregation and concentration of risk
catastrophes
non-disclosure and anti-selection.

3.2 Demonstrate the application of reinsurance as a risk management technique.

(Chapter 26)

3.2.1 Describe the purposes of reinsurance.

3.2.2 Describe the different types and structures of reinsurance.

3.2.3 Discuss the factors that should be considered in determining the level of
retention.

3.3 Demonstrate the application of underwriting as a risk management technique.

(Chapter 27)

3.3.1 Outline the purposes of underwriting.

3.3.2 Describe the different approaches by which underwriting is applied.

3.3.3 Discuss the factors that should be considered when determining the level of
underwriting to use.

The Actuarial Education Company © IFE: 2019 Examinations

Page 6 SP1: CMP Upgrade 2018/19

3.4 Propose further ways of managing the risks in 3.1, including: (Chapter 27)

claims management
data checks
product design
managing the distribution process and customer relationship
managing other counterparties
other internal processes.

3.5 Demonstrate the application of asset-liability matching as a risk management

technique. (Chapter 28)

3.5.1 State the principles of investment and how they apply to health and care
insurance.

3.5.2 Analyse health and care insurance liabilities into different types for asset-liability
matching purposes.

3.5.3 Propose an appropriate asset-liability matching strategy for different types of

liability.

4. Models and valuation (15%)

4.1 Describe the main features of a health and care insurance model.
(Chapters 11 and 17)

4.1.1 Outline the objectives and basic features of a health insurance model.

4.1.2 Compare the stochastic and deterministic approaches.

4.1.3 Compare a formula and cashflow approach.

4.1.4 Outline the basic features of multi-state models.

4.1.5 Explain the use of sensitivity analysis.

4.2 Understand and apply the techniques used in pricing health and care insurance
products in terms of: (Chapters 11, 12 and 17 to 20)

data availability
assumptions used
equation of value / formula approach
cashflow techniques
group risk assessments
options and guarantees
external influences.

© IFE: 2019 Examinations The Actuarial Education Company

SP1: CMP Upgrade 2018/19 Page 7

4.3 Demonstrate the different uses of actuarial models for decision-making purposes
in health and care insurance, including: (Chapter 11)

pricing products
developing investment strategy
projecting solvency
calculating embedded value.

4.4 Discuss the determination of supervisory reserves and solvency capital

requirements for a health and care insurance company. (Chapters 21 and 22)

4.4.1 Describe the purposes of reserves, solvency capital requirements and embedded
values, and the methodologies by which they are calculated for a health and care
insurer, including:

role of statistical and individual case estimates

setting assumptions, including a comparison with those used in pricing
market-consistent valuation
Value at Risk (VaR) capital assessment.

4.4.2 Discuss the interplay between the strength of the supervisory reserves and the
level of solvency capital required.

4.4.3 Compare passive and active valuation approaches.

5. Monitoring experience and setting assumptions (15%)

5.1 Describe the principles of setting assumptions for health and care insurance
business. (Chapters 13 to 16 and 19)

5.1.1 Describe the principles of setting assumptions for pricing health and care
insurance contracts.

5.1.2 Describe the principles of setting assumptions for determining liabilities.

5.1.3 Explain why the assumptions used for supervisory reserves may be different from
those used in pricing.

5.1.4 Outline the principles of setting assumptions for determining embedded value.

5.2 Demonstrate the relevance of experience monitoring to a health insurance

company. (Chapter 29)

5.2.1 Explain why it is important for a health insurance company to monitor its
experience.

5.2.2 Describe how the actual mortality, morbidity, claims amounts, persistency,
expense, new business and investment experience of a health insurance company
should be monitored, including the data required.

The Actuarial Education Company © IFE: 2019 Examinations

Page 8 SP1: CMP Upgrade 2018/19

5.3 Demonstrate the relevance of analysis of surplus or profit. (Chapter 29)

5.3.1 Give reasons for undertaking an analysis of surplus and an analysis of embedded
value profit.

5.3.2 Suggest ways in which the results of such analyses can be used.

6. Solving problems

6.1 Analyse hypothetical examples and scenarios in relation to the financial

management of health and care insurance companies. (Chapter 30)

6.1.1 Propose solutions and actions that are appropriate to the given context, with
justification where required.

6.1.2 Suggest possible reasons why certain actions have been chosen.

6.1.3 Assess the implications of actions within a given scenario.

6.1.4 Discuss the advantages and disadvantages of suggested actions, taking into
account different perspectives.

© IFE: 2019 Examinations The Actuarial Education Company

 SP1: CMP Upgrade 2018/19 Page 9

2 Changes to the Core Reading and ActEd material

There are numerous minor changes throughout the Core Reading and ActEd material.

This section contains all the non-trivial changes to the Core Reading and ActEd text.

Chapter 17
Section 1

This section (on IP pricing) has been amended (and reduced) significantly. Replacement pages are
attached.

Chapter 20
Section 2

This section has been amended significantly. Replacement pages are attached.

The Appendix has also been deleted.

Chapter 21
This chapter has been split into two new chapters:
Reserves and embedded value
Approaches to setting reserves and solvency capital requirements
and the following chapters have been renumbered accordingly.

A small amount of material on EV has been moved from Chapter 13 to the new Reserves and
embedded value chapter.

The material in these chapters is largely unchanged.

Chapter 27
Section 3.4, page 15

The penultimate bullet point (which was ActEd text) has been replaced by the following Core
Reading bullet point:

restrictions on the valuation method used

The Actuarial Education Company © IFE: 2019 Examinations

Page 10 SP1: CMP Upgrade 2018/19

Chapter 29
Some definitions required for Subject SA1 (previously marked ‘(UK)’ and now marked ‘(SA1)’)
have been deleted and others added. Details are not given here as they are only examinable in
Subject SA1.

The following definition has been added and is examinable in Subject SP1:

Wearable technology
Wearable technology is often in the form of devices worn by a health and care insurance
company’s policyholders, which allows the insurer to monitor the policyholder’s physical
activity. For example, some devices allow the tracking of the number of steps taken by an
individual on a given day. Some health and care insurers offer incentives and premium
discounts for consumers that wear this type of technology.

Chapter 30
A new chapter has been added on problem solving. A replacement chapter is attached.

© IFE: 2019 Examinations The Actuarial Education Company

 SP1: CMP Upgrade 2018/19 Page 11

3 Changes to the X Assignments

Overall
There have been minor changes throughout the handout, including changes to mark allocations.

More significant changes are listed below.

Assignment X1
The questions have been re-ordered, but the questions and solutions are largely unchanged.
Replacement pages are included for the questions.

Assignment X2
Question X2.7 now refers to a generic developed country rather than Actuaria.

Question X2.8 is now split into two parts:

(i) Describe the sensitivity tests you would perform before going ahead with the launch. [11]

(ii) Suggest any amendments that you might have to make to the product as a result of your
investigations. [4]

but the content of the solution is largely unchanged.

Assignment X3
Question X3.2 has been removed from this assignment and subsequent questions renumbered.

Question X3.3 has been expanded. Replacement pages are attached.

Assignment X4
Question X4.1 has been deleted and an alternative added in in its place. Replacement pages are
attached.

Question X4.3 has been reduced from [12] to [11] and the solution changed significantly.
Replacement pages are attached.

Question X4.4(ii) has been reduced from [8] to [6] and a new part has been added at the end.
Replacement pages are attached.

Question X4.5(ii) has been reduced from [6] to [5].

Question X4.6(i) has been reduced from [8] to [7].

Solution X4.7 has had its references to the conventional and North American methods removed.

The Actuarial Education Company © IFE: 2019 Examinations

Page 12 SP1: CMP Upgrade 2018/19

Question X4.8(v) has been reduced from [3] to [2].

The questions have been re-ordered.

Assignment X5
Question X5.7 now refers to a local reinsurer rather than NotonyourLife.

Assignment X6
No significant changes.

© IFE: 2019 Examinations The Actuarial Education Company

 SP1: CMP Upgrade 2018/19 Page 13

4 Other tuition services

In addition to the CMP you might find the following services helpful with your study.

4.1 Study material

We also offer the following study material in Subject SP1:

Flashcards
Revision Notes
ASET (ActEd Solutions with Exam Technique) and Mini-ASET
Mock Exam.

For further details on ActEd’s study materials, please refer to the 2019 Student Brochure, which is
available from the ActEd website at www.ActEd.co.uk.

4.2 Tutorials

We offer the following tutorials in Subject SP1:

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.

4.3 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 2019 Student Brochure, which
is available from the ActEd website at www.ActEd.co.uk.

4.4 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 SP1@bpp.com.

The Actuarial Education Company © IFE: 2019 Examinations

Page 14 SP1: CMP Upgrade 2018/19

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.

© IFE: 2019 Examinations The Actuarial Education Company

 ST1-17: Pricing (1) – Individual business Page 3

1 Income protection insurance

1.1 Inception / disabled life annuity approach

The inception / disabled life annuity approach provides a method of determining the expected
cost of benefits from claims incepting in a particular year.

The inception / disabled life annuity approach is a simplified model that considers two
functions, namely:

• the claim inception rate

• the disabled life annuity.

It ignores recoveries (or alternatively makes no distinction between recoveries and death)
and subsequent future sickness.

Claim inception rate

The claim inception rate, i xd , is the probability that a claim will become payable to an
individual in the year of age x to x + 1 . The individual will have become sick d weeks or
months (or years) earlier and remained so to benefit commencement.

Note that claim inception rates are different from sickness inception rates:
• Sickness inception rates relate to when individuals fall sick. In an IP insurance context, this
corresponds to the point in time when the individual is first deemed unable to work.
• Claim inception rates relate to the point in time at which benefit payments commence. In
an IP insurance context, this corresponds to the end of the deferred period.

Question

When would the sickness and claim inception rates be equal?

Solution

The sickness and claim inception rates would be equal when there is no deferred period, so that
the benefit payments commence immediately as the policyholder falls sick.

‘Claim inception rates’ are derived from ‘sickness inception rates’ by multiplying the
probability of sickness inception by the probability of remaining sick throughout the
deferred period.

Disabled life annuity

The disabled life annuity is the present value at the date of claim inception of expected
claim payments to individuals disabled after the deferred period until policy expiry.

Allowance is made for any escalation of the claim amount, interest and the probabilities of
death and recovery between the end of the deferred period and expiry date.

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Expected claims outgo

Within the cashflow program, the claims outgo in any period is taken as the lump sum value
of the benefit (annual amount × disabled life annuity) multiplied by the probability of
becoming eligible for claim (claim inception rate).

The final steps would be to allow for the probability of being alive and not currently claiming at
the point of making a claim and to discount the value of this claims outgo back to the date of
policy inception.

So, in summary, the expected present value of claims incepting in a particular year can be derived
as the product of the following five components:
(1) the probability that the policyholder is eligible to claim in the year under consideration
(for example, policyholders who are already claiming and policyholders who have died
before that year would not be eligible to claim) – this is sometimes referred to as a
survival probability
(2) the claim inception rate corresponding to the year under consideration
(3) the value of the annuity then payable for the duration of the claim
(4) a discount factor – this is needed to discount the annuity value from the point of claim
back to the policy inception
(5) the annual benefit amount.

Note that these components are not uniquely defined and that there are different types of
eligibility probability, claim inception rate and disability annuity.

1.2 Multi-state modelling

Multi-state modelling was introduced in Chapter 11.

The inception / disabled life annuity approach is a simplification of a more complex

methodology, multi-state modelling. With multi-state modelling, policyholders are
separately tracked through the various stages of ‘healthy’ and ‘claiming’:
• healthy premium payers
• lives falling sick within deferred period
• lives becoming claimants following deferred period
• lives recovering, reverting to premium payers
• lives dying.

Each subclass will have its own set of transition probabilities: sickness inception, lapse,
mortality, recovery, policy expiry.

Depending on the sophistication of the model, probabilities may vary according to the
number of previous times that the cohort has been ill and all transition rates may be a
function of the duration within that stage.

The actuary needs to recognise that the available data may not permit this degree of
sophistication of the method in practice.

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Recall from Chapter 11 that:

• in theory, the model could be very complex, with hundreds of sub-cohorts open at any
time
• in practice, the lack of detailed, credible data is likely to necessitate the combination of
various sub-cohorts and/or a reduction in the number of transition intensities required.

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 SP1-20: Pricing (4) – Options and guarantees Page 9

2 Valuing a mortality / morbidity option

2.1 Method
Mortality / morbidity options are normally valued using cashflow projections.

These cashflows would include the additional benefits expected to be payable under the
option and the additional premiums expected to be received in relation to these benefits, to
the extent to which the option is assumed to be taken up. The additional premiums would
be based on the expected premium rates that would be charged to standard lives for the
additional benefit, as at the option exercise date.

So, when policyholders exercise the option, they will pay exactly the same premium as a new
policyholder that has just passed underwriting on that day, ie they will be charged a premium
based on the select tables in use at that time.

The projections should also allow for any additional expenses incurred in the administration
of the option.

For example, expenses would be incurred if the insurer writes to each policyholder to remind
them of the option before the exercise date. Expenses will then be incurred in processing the
policyholder’s request to exercise the option.

If the purpose of the valuation is pricing the option, then allowance should also be made for
the additional reserves that should be held, both before and after exercise.

Question

Explain why a policy that contains a morbidity option is likely to need much higher reserves than
the equivalent policy without an option.

Solution

The existence of the morbidity option increases the morbidity risk. For example, an option to
extend the term increases the time for which the insurer is exposed to risk. Similarly, an option to
increase the sum insured increases the amount that is exposed to risk. The reserves need to be
increased for the expected cost of the increased claims.

However, reserves will also need to increase to reflect the uncertainty in this expected cost.
Alternatively, additional solvency capital will be required to cover these risks.

Before the option is exercised, the insurer is exposed to the risk that policyholders will selectively
choose to exercise the option if their health is worse than for a select life.

Even after the option has been exercised, the insurer is still exposed to considerable uncertainty.
As there is no further underwriting, it has no way of knowing the health of the lives that exercised
the option. Reserves will need to be calculated on the assumption that a level of anti-selection
has taken place.

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2.2 Assumptions needed

Valuing a mortality option therefore requires extra assumptions as part of the basis:

• the probability that the option will be exercised, at each possible exercise date

• the additional benefit level that will be chosen, if this is at the discretion of the
policyholder

• the expected mortality / morbidity of the lives who choose to exercise the option

• the expected mortality / morbidity of the lives who choose not to exercise the option

• any additional expenses relating to the option.

Option take-up rates

The model may assume that all eligible policyholders will take up the option, and that the
maximum additional benefit will always be taken.

You may see this approach (ie using the assumption that everyone exercises the option) described
as the ‘conventional method’ in past exam questions.

The assumption that everyone will exercise the option is unlikely to be borne out in practice, but
the method does have the advantage of simplicity.

If there are many possible dates on which an option may be exercised, or there is a choice
from several alternative options, the model may assume that the worst option from the
financial point of view of the company is chosen with probability one.

Alternatively, the model may use more sophisticated take-up rate assumptions which vary
by exercise date or by alternative option. These would ideally be based on past experience.

You may see this approach (ie making an assumption about the proportion of policyholders that
exercise the option) described as the ‘North American method’ in past exam questions.

This method uses a more realistic assumption for the option take-up rate than the first approach
suggested above. However, it may be difficult to obtain the data to make suitable assumptions
(historically this data was only available in North America, hence the name).

Mortality / morbidity rates

Typically, due to anti-selection, the expected mortality / morbidity of lives who take up the
option will be heavier than that of those who do not.

For example, the mortality of those who exercise the option may be assumed to be a higher
percentage of the base mortality table, eg those that exercise the option might be assumed to
experience mortality of 150% of the base mortality table.

Alternatively, an age loading may be applied (eg a policyholder of age x may be assumed to
experience mortality of age x + 5 years).

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It may instead be assumed that the mortality experience of those who take up the option will
be the Ultimate experience which corresponds to the Select experience that would have
been used as a basis if underwriting had been completed as normal when the option was
exercised. This would be consistent with an assumption that all eligible policyholders take
up the option.

So, this would be the approach to use under the ‘conventional method’ described above.

As noted earlier, there should be a link between the assumed option take-up rates and the
assumed mortality rates.

It may be assumed that the lives who do not take up the option will continue to experience
the same level of mortality as would have been assumed without the existence of the
option. However, this would mean that the average mortality for all lives has been assumed
to be in excess of the base mortality assumption, since those taking up the option are
assumed to experience higher mortality than this level.

For example, if lives that take up the option are assumed to be ‘ultimate plus ten years’ and the
lives that do not take up the option are assumed to be ‘ultimate’, then the average of their
mortality must be heavier than ultimate.

However, the average mortality of all lives (both those that take and do not take the option)
would be expected to be ultimate. To address this, the following alternative approach could be
used.

An alternative assumption would therefore be that the mortality of those who do not take up
the option is such that average mortality for all lives remains at the base expected level.
The assumed mortality of those who do not take up the option would then be lower than this
base level.

For example, under this alternative approach, the lives that take up the option could be assumed
to be ‘ultimate plus ten years’ and the average mortality would be assumed to be ultimate. If the
proportion that take up the option is 25% (say), then a mortality assumption could be determined
for the lives that do not take up the option, q′ , as follows:

qx = 0.25qx +10 + 0.75q′

The assumed mortality of those who do not take up the option, q′ , will be lower than ultimate,
for example, it might turn out that q′ = qx −3 .

Whilst the example outlined above discuss a mortality example, similar comments would
apply for morbidity.

2.3 Stochastic modelling

The core cost of options can be established through stochastic modelling. The future
experience is projected and the numbers taking up the various options and their
subsequent claim propensities are investigated. A large number of simulations will be
tested and the cost of the option will be calculated with a particular statistical degree of
adequacy.

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The model would have to subdivide the population of policyholders into different risk categories,
such as groups (1) and (2) as defined in the previous section, and quite possibly including
additional subgroups within these. The proportions ending up in each risk group and also the
average claim experience of each risk group at the option date could be modelled as stochastic
variables. We would therefore need appropriate probability distributions for these.

Question

Suggest briefly how we could model the effects of the kinds of large changes to option costs
described in Section 0.1, eg as a result of a significant increase in the prevalence of a particular
disease.

Solution

It is very difficult to include this degree of uncertainty in a stochastic model with any confidence
about the probability distributions that would need to be assumed. Instead the stochastic model
would probably be run several times incorporating major ‘what-if’ shifts to the underlying
parameters of the assumed probability distributions.

So, for example, our assumption shifts could imply significant changes to the expected
proportions in each risk group, and to the expected morbidity of each group, and the model
would be rerun to see the effect this might have on the simulated distribution of option costs and
hence on the required option premium.

This is an example of sensitivity testing in a stochastic modelling context.

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Problem solving
Syllabus objectives
6.1 Analyse hypothetical examples and scenarios in relation to the financial
management of health and care insurance companies.
6.1.1 Propose solutions and actions that are appropriate to the given context, with
justification where required.
6.1.2 Suggest possible reasons why certain actions have been chosen.
6.1.3 Assess the implications of actions within a given scenario.
6.1.4 Discuss the advantages and disadvantages of suggested actions, taking into
account different perspectives.

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0 Introduction
The examiners will expect candidates to be able to apply the knowledge and understanding
they have developed through the study of the Subject SP1 Core Reading to produce
coherent solutions and actions in relation to the financial management of a health and care
insurance company.

Students are expected to be able to combine ideas across the chapters in the course, and
apply them to scenarios proposed by the examiners.

From your studies of the earlier chapters you should now have a firm grasp of all of the issues
central to the financial management of a health and care insurance company. However, the
course has had to introduce these in a relatively isolated fashion. But, as the Core Reading above
makes clear, you may be asked in the exam to combine these issues together to solve various
problems that health and care actuaries may face.

This chapter takes a look at the financial mechanics of the health and care insurance company,
considering how the different parts of the course come together. The material should not be
new, but it should represent some new perspectives. Thinking through the ideas in this chapter
will help to generate ideas in the exam, particularly for questions that cover a wide range of
topics.

In particular, it covers:
• a health and care insurance company income statement and balance sheet
• the lifetime of a policy
• the interested parties in the health and care insurance world
• the control cycle.

The chapter then finishes with some longer practice questions to help you develop your problem
solving skills.

Note that, as this chapter discusses exam technique rather than adds new technical material, it
does not have a summary section.

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1 Health and care insurance company accounts

One approach that can be useful to generate ideas is to consider each element of the accounts in
turn.

To ensure you understand fully where health and care insurance company profits come from, it
makes sense to consider what a health and care insurance company income statement and
balance sheet normally look like. The exact form that they take will depend on local statute and
practice. For example, it is common for the policyholder cashflows to be dealt with in a revenue
account, and for profit from that account to then pass through to the income statement (or ‘profit
and loss’ account), which adds in the impact of shareholders’ assets to give a final result for the
company. Here, everything is assumed to ‘happen’ in the revenue account.

1.1 The revenue account

A health and care insurance company revenue account might look something like:

Premiums positive
Investment income positive
Increase in reserves negative
Benefit payments negative
Expenses negative
Commission negative
Profit / loss (pre-tax)
Tax payable negative
Profit / loss (post-tax)
Dividends to shareholders negative
Transfer to balance sheet ‘shareholders’ retained profit’

This should be intuitively very familiar. One useful application is as a way of generating ideas
about the financial impact of any action, both in terms of the individual elements that might be
affected and the ‘bottom line’ effect on profit.

Question

How will the sale of a new policy affect the above items?

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Solution

Writing a new policy will have the following impact:

Premiums increase to the extent of the premium concerned (or slightly less, if we are considering
a policy sold during the year with premiums payable eg monthly).

Investment income will not change significantly: on average there will be a half-year’s interest on
the premium less expenses and benefit outgo.

The reserves will increase in proportion to the premium. If the statutory valuation basis is
stronger than the realistic assumption basis used in pricing (and/or if there is a solvency capital
requirement), the company will suffer valuation strain and the proportion ‘increase in reserves
and solvency capital as a percentage of premium’ will generally be higher.

Expenses will increase, due to the underwriting, marketing and administration costs involved.
Note that this question is about the marginal effect of selling one policy: thus the expenses from
overheads which need to be attributed to policies in other contexts (eg pricing) are not relevant
here.

Commission will increase if the policy was sold through commission-rewarded brokers / agents.

Benefit payments are likely to increase, but not significantly (unless the policy is a contract of
duration one year or less).

The net effect is likely to be a loss (unless there is some financial reinsurance arrangement).

In this case, it is almost certain that no tax will be incurred in respect of this (considering the two
common tax bases, profits and ‘investment income less expenses’).

Total shareholder profits will therefore be reduced by the sale of the policy. (This means reduced
from what they otherwise would have been; it does not necessarily mean reduced compared with
the previous year.)

The account shown here gives the basic idea. Many variations are possible:
• There might be separate entries for ‘increase in reserves’ and ‘increase in required
solvency capital’, or the required solvency capital may be excluded from the accounts
(depending on the purpose).
• Instead of ‘increase in reserves’, there could be two entries: ‘reserves brought forward at
start of year’ and ‘reserves carried forward at end of year’. A similar split could then be
made for required solvency capital as well.
• Commission might be included in expenses (or there may be no commission at all).
• Benefit payments might be split into their components.

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Question

What are the components of the benefit payment entry?

Solution

The components of benefit payments will be:

• claims (lump sums)
• claims (annuity instalments)
• surrenders.

‘Waivers of premium’ might also fall into this category.

• Investment income might or might not include unrealised capital gains.

• Reinsurance might be implicit in the items (so ‘premiums’ is really ‘gross premiums’ less
‘premiums ceded under reinsurance’) or it might be split out.
• Surrenders and lapses might be implicit in the items (so ‘commission’ is really ‘commission
less commission recovered from early discontinuance’) or they might be split out.

One consequence of these possible variations is that, if an exam question presents any form of
revenue account, or talks about some revenue account item such as ‘benefit payments’, you need
to be aware of what each item really means. If not made clear, and it is important, you need to
specify your assumption (for instance, whether ‘profit’ is post-tax or pre-tax), or to consider both
cases. Areas to watch out for are:
• Is the figure net or gross of reinsurance?
• Is the figure net or gross of discontinuances?
• Does the figure relate to the particular line of business only, or the whole company?
• What about tax?

Question

How will the cashflow of the company differ from the revenue account?

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Solution

At its simplest, the cashflow will be the total of all of the items excluding the increase (or
decrease) in reserves (and required solvency capital). This is because the increase in reserves is
really just a reallocation of monies inside the company, while all of the other items involve real
cash being paid to or by the company.

If accounts are prepared with assets valued at market value, then the revenue account may
include unrealised capital appreciation / depreciation but the corresponding amounts will not
feature in the cashflow.

It is also possible for the expense figure in the revenue account to include an allowance for
depreciation, while there will be no corresponding cash movement in that year (there will in fact
have been a cash payment in respect of that amount in some previous year).

So the cashflow is:

premiums
+ investment income (excluding unrealised gains / losses)
– benefits
– actual expenses (ie excluding depreciation / amortisation)
– commission
– tax

1.2 The balance sheet

The presentation of health and care insurance company balance sheets seems to vary even more
than that of revenue accounts. In essence, they are extremely simple, with total assets equal to
total liabilities (including shareholders’ capital and retained profits).

Consider the relationship between the revenue account and balance sheet.

Example
The balance sheet for Abingdon Health and Care insurance company as at 31 Dec 2015 is:

£ millions

Assets Liabilities
Share capital / retained profit 45
Reserves 114
Total assets 159 Total liabilities 159

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The revenue account for the year 2016 is as follows:

Premiums written 46
Investment income 18
Increase in reserves (41)
Benefit payments (8)
Expenses (3)
Commission (6)
Profit / loss (pre-tax) 6
Tax payable (2)
Profit / loss (post-tax) 4
Dividends to shareholders (1)

Transfer to balance sheet

‘shareholders’ retained profit’ 3

Question

Calculate the 31 Dec 2016 balance sheet, and the company’s free assets at that date.

Solution

The balance sheet will be:

£ millions

Assets Liabilities
Share capital / retained profit 48
Reserves 155
Total assets 203 Total liabilities 203

The mechanics are as follows:

• Share capital increases by the retained profit transferred to balance sheet of 3.
• Reserves increase by the increase in reserves.
• Total assets will have varied in accordance with the cashflow:
159 + 46 + 18 – 8 – 3 – 6 – 2 – 1 = 203
• Free assets = total assets less non-shareholder liabilities = 203 – 155 = 48
• Alternatively, free assets = shareholders’ capital = 48
• Check that the two sides balance: 203 = 48 + 155

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1.3 Solvency capital requirement

In all of the above, how would any solvency capital requirement (SCR) come into play?

The company might build up the SCR via the revenue account in the same way as it builds up
reserves. This is the approach that you would need to take in profit testing / model office work.
However, it is often the case that the SCR is not seen in any way in the revenue account.

Even in the balance sheet, where you might reasonably expect to see the SCR, it is common for it
not to be shown explicitly in the published accounts. However, the company will need to
demonstrate to the supervisory authority that, given the balance sheet as at a certain date, the
SCR as prescribed by statute can be covered by shareholders’ capital and retained profit (so you
would expect to see the SCR in the supervisory balance sheet).

For instance, in the example of Abingdon Health and Care as at 31 December 2015, the company
might have needed to show that the figure of £45m for shareholders’ capital and retained profit
exceeded the SCR at that date of £6m (say).

So you may or may not see the SCR in either the revenue account or the balance sheet. The
approach used will depend on the purpose of the calculation (eg reporting profit to shareholders
or demonstrating solvency to the supervisory authorities) and the regulations that apply in that
country.

Question

How will the sale of a new critical illness insurance policy affect the balance sheet at the end of
the year?

Solution

Writing a new policy will have the following impact:

The assets will be:

• increased by the premium coming in – since CI insurance policies have relatively small
premiums (as the insured event isn’t certain to occur and also, most CI insurance policies
are regular premium), the assets will be increased by only a small amount
• reduced by the initial expenses and any commission paid – underwriting expenses could
be very significant as the policy has a large sum at risk; initial expenses of writing the
contract will also be large compared to the relatively small regular premium.

Overall, the expenses and commission will outweigh the premiums and the assets will fall.

Any claims that occur before the end of the year will reduce assets further. The contract will have
provided no assets to contribute any investment return at this stage (in fact the asset share is
negative, so any interest attributed to the contract would be negative).

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If reserves are calculated on a prudent basis, then reserves are likely to increase following the sale
of the contract. Alternatively, the insurer may be required to hold more solvency capital to cover
the increased risk from selling this contract. So the total of reserves and required solvency capital
will rise.

Therefore overall, the balance sheet will show a fall in assets and a rise in reserves / solvency
capital. Hence the shareholder capital will fall (as the assets must equal the liabilities, ie the
balance sheet must balance).

This is consistent with the question at the start of this section that showed that writing new
business could result in a loss on the revenue account.

The first and last questions in this section indicate that considering the elements of the accounts
in turn can generate a good description of the impact, in this case of writing new business, on the
insurance company.

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2 The life and times of a policy

A useful way for thinking about how a health and care insurance company functions is to consider
all of the stages involved in the lifetime of a policy. This can also be a good way to generate ideas
in the exam, particularly for questions where a change is being considered by the insurer.

It can be broken down as follows:

• the idea
• the sale
• the first day
• a typical year
• the last day
• even later days.

2.1 The idea

You can argue that the lifetime of a policy starts with the product itself being created. This will
reflect:
• some perceived market need for the product
• a regulatory and taxation environment that makes the product both possible and practical
• the company wanting to write such a product.

Once the company decides that it wants to write the product, the next stage will be product
design.

Question

What will be the main steps in product design and pricing?

Solution

The main steps in product design and pricing will be:

• formulate the structure of the product (with marketing)
• decide on the assumptions for expenses, interest, mortality, persistency
• profit test to give premiums to meet a set profitability target
• given these premiums, sensitivity test and decide whether to adjust premiums or design
• compare with competition and adjust premiums (especially for expense loadings/charges)
• run model office with expected tranche of new business – determine if there are any
capital, tax or expense problems, and whether it is worthwhile in terms of impact on EV.

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2.2 The sale

The policy now needs to be written. Or, as a marketing manager might say, ‘the policy needs to
be sold’.

The sale process will depend greatly on whether the sale involves members of the public being
approached, or whether the initiative is taken by the public – eg they decide to go and ask a
broker about a CI insurance policy.

Looking at the agent / broker sales process:

The first thing will be when some innocent member of the public, Mr X, thinks that he might need
a policy of a particular type. This might be pre-empted by advertising by this insurance company,
or (more likely) by any other health and care insurance company, about such a contract. The
other main avenue would be if the prospective policyholder is doing something that entails
getting insurance – eg much CI assurance will be written as a result of people taking out
mortgages on a house purchase, for example.

Mr X then decides to do something about his idea. He visits a high street broker, or the insurance
adviser at his bank or building society.

Suppose the high street broker works with a number of health and care insurance companies (ie it
is ‘independent’ rather than ‘tied’). In that case, the broker will ask Mr X about his finances and
requirements, decide on which insurance companies’ products are most suitable, and show Mr X
the relevant marketing literature from those companies. The broker might indicate just one
contract, which he judges to be the most suitable for Mr X. Any commission that the broker
might receive on sale of the contract should not be an influence on the contract recommended.

The broker could also produce a ‘quote’ – ie the premiums and benefits to which Mr X would be
entitled – given Mr X’s age and gender, and intended premium (or required benefit). The quote
could be done on the broker’s PC using software supplied by the companies. Alternatively, there
might be a web-based quotation system. In some markets, rate tables are still used, ie the broker
would calculate the premium by hand using a printed copy of the insurer’s rates.

Question

How would the above procedure differ if Mr X had approached his bank’s insurance adviser, and
his bank has its own insurance subsidiary?

Solution

The advisor would recommend one of the bank’s products (unless there was absolutely nothing of
the right type). The quote would come from the bank’s computer system, or from a PC.

Assume that sensible Mr X decides to take out our company’s CI insurance product.

First, he will need to fill in a proposal form.

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Question

State the information required on the proposal form.

Solution

• personal information, such as name, address

• policy information, such as premium and benefit proposed, and any options
• medical information, such as own and family medical history, current or recent illnesses,
height and weight
• lifestyle information, such as smoking and drinking habits, occupation, dangerous hobbies
• financial information, such as income, and whether the applicant has any other CI policies
• bank details if payment is to be by automatic deduction from account

Next, the proposal form goes to the health and care insurance company.

If the answers to the medical questions raise any doubts, or the sum insured is over a certain
level, some form of extra medical evidence might be required.

Question

What extra medical evidence might be asked for?

Solution

The extra medical evidence could be:

• a report from Mr X’s regular doctor
• a general medical examination
• specific medical tests such as an ECG (electrocardiogram).

The company would also consider the financial condition of Mr X to ensure that the policy is
appropriate given his probable needs and lifestyle.

If the sum insured is particularly high the health and care insurance company might need to
contact its reinsurer to ensure that it is appropriately covered.

If there are no problems, and the proposal is accepted by the company, the proposal data will be
fed into the health and care insurance company’s policy administration computer system and the
system should print out the policy. Mr X will then be sent the policy (a health and care insurance
policy is in reality a legal contract printed on paper, signed by the policyholder and the insurance
company) and cover will commence on the agreed date, probably subject to satisfactory payment
of premium.

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(The premium might be paid to the broker, rather than direct to the health and care insurance
company.)

Question

Summarise the main differences to the above description if Mr X had taken out the policy via a
direct marketing telesales channel.

Solution

Mr X sees an advertisement in the paper and rings the number.

He is given a brief description of the product on the phone, and then needs to give his address so
that the company can send an information pack.

This would include information about the product, about the insurance company and might
include quotes for X’s age / gender / premium if that was sorted out in the telephone call.

The pack might also include a proposal form for Mr X to fill in and send off. This might include
some underwriting questions.

On receipt of this, and possibly conditional on appropriate payment and responses to

underwriting questions, the insurance company would produce the policy and send it to Mr X.

2.3 The first day

On cover commencing, the policy becomes a liability of the health and care insurance company.
The insurance company therefore needs to establish suitable reserves (and if there is a solvency
capital requirement, then this will also need to be considered). The reserves may be calculated
on a more prudent basis than the premium basis (and/or the requirement to set aside solvency
capital will build in a level of prudence). If this is the case, then the company incurs some capital
strain at inception – ie the cost of reserving for the policy is greater than that assuming the
(realistic) premium basis.

The company must also pay the acquisition costs of the policy. In the example of the broker, this
would probably entail the company’s account department crediting the broker’s account with the
commission amount (alternatively the broker may receive a fee directly from the policyholder)
which would depend on the market, the insurance company, the product and the broker. The
broker will then receive actual cash when the account is settled, which might be done, say,
monthly.

In addition, the policy will have cost a certain amount to set up on the insurance company’s
administration system, to administer the proposal / policy and to cash and invest the premium.

These expenses (including commission) are the initial marginal expenses of the company in
respect of the policy, and it is vital that the expense loadings or charges in the contract cover
these.

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However, it is normal to expect every policy to contribute something to cover the other expenses
of the company – for example, the overheads of the company, or the development costs of the
contract. This contribution would normally be expressed per policy, or possibly in relation to
premium size. This will go into the ‘initial expenses per policy for contract Y = £270’ figure which
came out of the expense investigation – the product should be priced on the basis of these
suggested loadings. But the contract’s loadings might not be equal to these suggested expenses,
perhaps because the contract was priced two years ago and the expense experience of the
company has changed since then, or because the balance between ‘fixed per-policy expenses’ and
‘percentage of premium’ expenses has been adjusted for competitive reasons.

So, the insurance company might make an expense profit or loss if the required contribution to
current expenses is lower or greater than that assumed in the premium basis.

Moving on from considering the expenses in isolation, what is the overall impact on the
company’s financial results?

Considering the income statement earlier, for an annual premium contract, the insurance
company might see on the first day an effect along the lines of:

Premium P
Increase in reserves 0.95 × P
Expenses 0.6 × P
Commission 0.8 × P
Profit / loss –1.35 × P

So, writing that policy will have required the insurance company to find capital of 1.35 × P. That
money will have been provided by the free assets of the company.

Lucky Mr X. The company has been prepared to suffer an income loss of 1.35 times his premium
so that he could have his favourite insurance policy. (Remember, this has assumed a full expense
figure, including a contribution to overheads, rather than the marginal expense involved.)

In fact, the insurance company would need to find even more capital than this if there is some
solvency capital requirement (any weakness in the reserving basis is likely to be offset by stronger
capital requirements). For example, if there is a requirement of 0.05P in respect of the policy
then the insurance company has to find capital of 1.4P to write that business.

So the revenue account impact is: a loss. This will often be the case for a regular premium policy.
A single premium policy might give some loss, primarily due to capital strain, but the size of loss
(in relation to the premium) would be much lower than that seen with a regular premium
contract.

Question

What is the embedded value impact of writing the policy?

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Solution

If the policy is profitable on the embedded value basis, the embedded value will increase. This
will normally come from a large increase in the present value of future profits and a small
decrease in free assets.

2.4 A typical year

Several years have passed since that exciting first day. What might happen in a typical uneventful
year?

Consider the financial impact of the policy on the revenue account of the company. At the start
of the year the policy will be ‘visible’ in the balance sheet, via its associated investments on the
assets side and reserves and shareholders’ retained profit on the liabilities side.

During the year Mr X faithfully pays his premium. At each policy anniversary, or perhaps at 31
December, the insurance company may determine the surplus arising. That surplus will be the
result of experience having been better than that assumed in the valuation basis.

Question

The premiums coming in every year are calculated on the premium basis, so why isn’t the surplus
the result of experience being better than the premium basis?

Solution

As soon as the insurance company receives a premium, it has to set up the necessary reserves for
the policy concerned (and be able to cover any solvency capital required). For simplicity, assume
that the valuation basis contains margins for prudence and there is no requirement to hold
solvency capital.

As the valuation basis is more prudent than the premium basis (usually) the insurance company
will record an immediate loss. This is the capitalisation of all the future losses the company is now
expecting to make, from a policy whose premiums are inadequate to meet its liabilities according
to the reserving basis assumptions of the future experience. The basis underlying that premium
becomes irrelevant from this point: having set up these reserves, the insurance company will not
make any (more) loss, or profit, if its experience is exactly that of the reserving basis. Hence, if
the actual experience is better than its reserving basis, then a profit will be recorded in the
insurance company’s accounts.

Assuming that the policy is a regular premium policy, how would its passage through the year be
reflected in the revenue account?

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At the end of the year, the revenue account might look something like:

Premium P
Investment income 0.01 × P
Increase in reserves (0.1 × P)
Benefits (0.55 × P)
Expenses (0.1 × P)
Renewal commission (0.06 × P)
Surplus (profit) 0.2 × P

Assuming that tax is paid on profits at 40%, the revenue account would continue:

Surplus (profit) 0.2 × P

Tax (0.08 × P)
Profit net of tax 0.12 × P

So the shareholders make a small profit. In fact, the original pricing of the contract should have
been such as to ensure that the profits that emerge in subsequent years are sufficient to repay
the initial new business strain, valuing at the risk discount rate.

What is the effect on embedded value?

Question

If experience is worse than that in the embedded value basis, how will the embedded value move
over the year?

Solution

If experience is worse than expected then there will be two effects:

The free assets will not increase by as much as expected. (This could equally appear as the free
assets decreasing by more than expected, or the free assets decreasing when an increase was
expected.) This corresponds to the immediate profit consequences of this experience (ie less
profit – or more loss – than expected).

The PVFP might be decreased. In the case of decrements (claims and withdrawals) their PVFP will
no longer contain the future profits of those ‘extra’ policies which have gone off the books.

Both of these will lead to a reduction in embedded value. The effect on free assets will normally
be much greater than the effect on PVFP. However, there might be instances where the opposite
is true (eg if the bad experience in question is a high lapse rate for CI policies).

Furthermore, if the experience then moves you to change the embedded value assumption set,
then the PVFP could be significantly affected.

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2.5 The last day

Sadly, Mr X is diagnosed with a CI. After obtaining the required medical evidence, the health and
care insurance company sends him a cheque for the sum insured.

Settling the claim will involve some expenses.

If the policy comes under any reinsurance arrangement then the insurance company will get some
money back from the reinsurer. This will not happen there and then – the insurance company will
receive the money when the reinsurer settles the relevant quarter’s account (if the reinsurance
accounts are quarterly – which is common practice).

Question

What is the impact of the claim on the insurance company’s financial results?

Solution

There will be a loss equal to the difference between the amount paid and the policy reserve.

Question

What is the impact of the claim on the company’s embedded value?

Solution

The net asset value will take a loss as per the revenue account result in the previous question –
but note that it would be net of tax.

The present value of future profits component will suffer a small loss due to the fact that that
policy will no longer be contributing profits to the company. However, if the experience for the
portfolio as a whole is as per the embedded value basis, then the present value of future profits
for the portfolio will not decrease in this way.

2.6 Subsequent to the last day

Question

How might the policy affect the health and care insurance company after that last day?

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Solution

Possibilities here are:

• the insurance company retrospectively contests the claim and gets the money back in the
event of fraud (eg faked medical evidence)
• the insurance company contests the claim and gets some money back (eg extra
premiums) in the event of false information on the policy proposal form coming to light
• the insurance company tries to cross sell health and care insurance products to Mr X
and/or his family, trying to sell a policy appropriate to the recent receipt of the claim
payment (eg an annuity to give regular income, or a simple single premium savings policy)
• Mr X’s claim will appear in the insurance company’s claims investigation, and will
eventually feed into the assumption sets used for future modelling work.

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3 Different parties in the insurance world

One way to create ideas when thinking about certain health and care insurance issues is to
consider the various different stakeholders who may be affected, or in any way interested, and
what their standpoints are.

The following parties may be relevant in a health and care context:

• policyholders
• future policyholders
• dependants / relatives of policyholders
• employers
• the health and care insurance company:
– shareholders
– management
– underwriters and claims managers
– actuaries
– marketing department
– administrators
• other health and care insurance companies
• sales channels
• reinsurers
• providers of health and care services / facilities
• the State (government)
• the regulator
• taxation authorities
• others.

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3.1 The policyholders

Policyholders will ideally want:
• products that meet their requirements (eg appropriate deferred period / level of cover)
• products that are easy to understand
• a smooth and simple process (eg guaranteed premiums, fast and simple claims
management)
• products that allow them to take advantage of any tax breaks
• affordable premiums and value for money
• benefits that keep up with inflation
• high security of benefits (eg financially strong companies).

Note that many of these desires may conflict.

3.2 Future policyholders

Question

In what way will the desires of members of the public who see themselves as potential future
policyholders, differ from the views outlined above?

Solution

Members of the public will also want:

• a smooth sales process (eg easily accessible sales agents, simple underwriting)
• a large choice of health and care insurance companies.

3.3 Dependants / relatives of policyholders

Question

What additional needs might dependants / relatives of policyholders have?

Solution

Dependants and relatives might also want:

• provision of advice (eg on suitable care facilities for long-term care policyholders)
• flexibility and choice (eg over hospitals / care facilities used).

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3.4 Employers
Employers are essentially policyholders and so will have similar wants and needs to those outlined
above. However, they might also be concerned about:
• having the flexibility to change benefits each year (as employee needs / the environment
change)
• straightforward and simple means of communication between employees and the insurer
• premium guarantees from year to year.

3.5 The health and care insurance company

There are many stakeholders within an insurance company. Here are a few key ones:

Shareholders
Shareholders will want:
• a return on their investment of at least the risk discount rate, and ideally as high as
possible
• low risk (so a low probability of the value of their shares plummeting)
• smooth supply of dividends (so low volatility of financial results)
• in theory, useful financial information (eg embedded value results as well as traditional
revenue account and balance sheet).

Management
Health and care insurance company management should want to:
• maximise long-term profits
• ensure that the company operates legally (ie demonstrates supervisory solvency,
complies with regulations etc).

However, in order to be seen to be doing something, they may want to:

• maximise short-term profits, and/or
• maximise new business levels (probably short-term).

Underwriters and claims managers

Underwriters will want to ensure that:
• the process is not too onerous (and off-putting) to applicants
• policies are underwritten quickly and efficiently
• the risks taken on meet the company’s objectives
• relevant, accurate data is obtained (for use in reserving, claims management etc).

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Claims managers will want to ensure that:

• the claims paid are both genuine …
… and reasonable (ie not excessive)
• claims are paid in a timely manner
• the company’s reputation is not damaged.

Actuaries
Depending on the context, it might be possible to split this category of stakeholders even further,
for example, the pricing actuary, the reserving actuary etc.

Question

What will be the actuary’s aims?

Solution

The actuary will want:

• to conform to statute and regulations
• to conform to professional guidance
• generally to work to a highly professional level (eg concern about policyholder fairness)
• to work for the company to increase its profits, subject to not going against policyholders’
expectations.

Marketing department
The health and care insurance company marketing manager will normally want to:
• maximise new business levels.

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3.6 Other health and care insurance companies

Taking the perspective of any one health and care insurance company, other health and care
insurance companies will want to maximise their profits and (probably) new business levels.
There are a number of possible ways in which they might try to outperform their competitors:
• lower premiums from a lower profit margin
• lower premiums from lower expenses (perhaps from economies of scale)
• better investment performance (historic and expected)
• better administrative service
• quicker and simpler underwriting
• greater brand awareness
• appeal to different target markets
• specialist (niche) products
• product designs that are easier to understand
• greater security of policy benefits (eg guarantees on future benefits and/or premiums)
• greater security of insurance company (by demonstrating higher free assets)
• greater incentivisation of sales channels (often, higher commissions)
• more incentives for policyholders (free gifts, enhanced benefits, loyalty bonus).

3.7 Sales channels

Sales channels (ie brokers, agents and direct sales forces) will want to:
• maximise their remuneration
• provide a good service
• provide suitable products
• build up a portfolio of happy customers.

Question

What are the implications of sales channels wanting to maximise their remuneration?

Solution

Sales people will often want to sell those products that give them the highest remuneration,
rather than sell the product that is best for the customer. From a strictly financial and
quantitative point of view, their only interest in the suitability of the product for the customer is
the fact that a well-matched product should show good retention and so bring in future renewal
commissions.

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In reality, sales people may not be completely influenced by commission, because:

• they want to offer a good service to attract business in the long term
• they may have a sincere interest in the suitability of the product for the customer.

3.8 Reinsurers
The aim of reinsurers is to maximise their long-term profit, subject to operating legally
(eg demonstrating solvency). They will do this by:
• charging premiums that cover the cost of the inherent risk, plus their expenses and some
profit margin
• helping insurance companies to reduce the cost of claims by providing underwriting
advice and assistance
• attracting business by:
– offering high commission on business ceded by insurers
– offering advice on pricing, underwriting and other areas
– by demonstrating financial strength
• charging premiums that are competitive compared with other reinsurers (and competitive
with respect to the alternatives to reinsurance that health and care insurance companies
might consider)
• offering reinsurance and expertise for new risks (perhaps using their research and
experience from other markets).

In addition, in the interests of short-term profit stability, they may reinsure some of the business
that they have taken from direct writers.

3.9 Providers of health and care services / facilities

This includes the staff that run the facilities (surgeries, hospitals, specialist facilities, care
homes etc) and the individuals who provide the care (doctors, nurses, surgeons, consultants etc).

Their objectives may be profit-related:

• charging prices that are adequate to cover the marginal and overhead costs of the
facilities
• attracting enough customers to make sufficient contribution to overheads and/or to
achieve economies of scale
• negotiating deals with suppliers
• being efficient

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or service-related:
• providing treatments / care with certain target success rates
• providing treatments / care that meet the expectations of patients
• providing treatments within specified time frames.

3.10 The State (government)

The specific objectives of the government in relation to health and care were covered in Chapter
10.

For each of the four main objectives, there are likely to be specific targets / goals, for example:
• protecting the nation’s health:
– target waiting times for various treatments
– a target number of research projects conducted each year for various illnesses
• subsidising the poor:
– targets to narrow the level of inequality between the rich and the poor
– targets to reduce the number of people living in poverty / without access to basic
facilities
• balancing the budget:
– overall targets, eg ensuring that tax revenues cover overall government
expenditure over the course of the economic cycle
– specific targets on healthcare spending, eg to keep increases in real spending
below 2%pa
• following social culture and/or political promises.
– a target to keep the population (especially the voters) happy and to get re-
elected.

More generally, the government is likely to have the following additional aims that relate to
health and care insurance companies:
• to ensure that the legal framework maximises policyholder security
• to incentivise products that are considered socially desirable (eg PMI where no State
healthcare exists)
• possibly to assist policyholders of insurance companies that go insolvent
• to encourage a fair and competitive marketplace.

The Government may also act in its own interests, for example:
• by forcing health and care insurance companies to invest in large amounts of government
bonds
• by protecting the monopoly (and profitability) of any State insurer.

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Question

How might the Government encourage a fair and competitive marketplace?

Solution

• through restrictions on monopolies within the health and care insurance sector
• by ensuring that companies present their products in a consistent way (eg all benefit
projections done on the same assumed investment return, regulation on advertising and
sales processes)
• by ensuring that different sectors – eg banks vs health and care insurers vs personal
investment providers – all enjoy equivalent regulation and tax treatment (both from the
point of view of the companies and the ‘consumers’)
• by encouraging cross-border freedom between countries as far as the provision of
insurance policies is concerned

3.11 The regulator

The regulator will want to:
• ensure health and care insurance companies act in compliance with the law and
regulations
• ensure health and care insurance companies remain solvent in the future
• ensure that policyholders are not mistreated
• ensure that potential policyholders (ie customers) are not misled.

3.12 Taxation authorities

The taxation authorities will want to
• maximise tax income (subject to what the tax laws allow).

3.13 Others
The list could continue. Here are a few examples.
• other employees of health and care insurance companies, who will have a considerable
personal interest in the financial prosperity of the company
• investment analysts, who will be interested in the financial prospects for the insurance
company’s shares, if it is proprietary
• Non-health and care insurance companies, banks, building societies etc, whose businesses
in some way compete with the health and care insurance market.

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4 The control cycle revisited

It’s a useful exercise to look again at the control cycle (introduced in Subject CP1), but this time
applying all of the knowledge built up in Subject SP1.

In essence, the control cycle can be thought of as the best way for a health and care insurance
company to operate. In any situation, the company will have some aims shaped by the business
environment. What are the risks that might impinge on these aims? Given those risks, what is
the best approach? Eventually, in the light of experience, was the perception of risks correct, and
was the selected approach the best or can it be improved?

The following example is presented as a possible exam question and solution. It is laid out
without marks so that you can concentrate on the ideas involved rather than on exam technique.

Question
In the country of Ruritania, health and care insurance premiums are paid out of net income and
benefits above certain levels are subject to special rates of tax.

For political reasons, the Government of Ruritania has just passed legislation allowing house-
owners to buy accelerated critical illness policies up to the value of their house tax-free
(ie premiums will be payable from pre-tax income and the benefit will be tax free).

The health and care insurance company of which you are the product-design actuary wants to
take advantage of this to launch a new range of accelerated critical illness products.

Describe:
(a) the risks faced by the company
(b) possible solutions to these risks
(c) how the company might then modify its chosen approach in the light of experience.

You should now spend 5-10 minutes on writing down an outline solution, just putting down the
keywords (rather than details about expense investigation mechanics etc).

Having done that, now read through the Syllabus in the Study Guide and check that you have not
missed out any areas which might affect your solution. Then read on.

Solution
Note that this is written in ‘ActEd course note’ style rather than ‘standard exam solution’ style.

(a) Risks

The company’s aims will be to stay solvent, and subject to that, almost certainly to maximise
profits. What are the risks that might affect these aims? The risks here are the various areas
covered in part 3.1 of the Syllabus. The main risks (and the ones covered below) are mortality and
morbidity, expenses and persistency.

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Mortality and morbidity

Fundamentally, the risk is that of actual mortality / morbidity exceeding that priced for. This risk
can be broken down into the three components of model risk, parameter risk and random
fluctuation.

There is the model risk that the expectations of mortality / morbidity are not correctly modelled –
for example, they might be modelled as constants when they will in fact vary over time.
Furthermore, the model might omit certain claim types, for example, new types of cancer that are
not currently known about, but would be covered under the policies.

There is the parameter risk that the estimates of mortality / morbidity, and hence the parameters
that define the modelled versions of mortality / morbidity, will not be correct.

To estimate mortality and morbidity, the insurance company will need to look at its experience
with its current accelerated CI contracts (assuming it has some), and possibly also related
contracts, eg stand-alone CI insurance. However, the policyholders eligible for this new product
may be significantly different from those in the insurance company’s existing portfolio, or those
underlying any other statistics that the insurance company may look at (industry data, reinsurers).

Mortality and morbidity rates are likely to change over time. This might be a gradual change,
eg standard mortality improvements, or a one-off change, eg a change in critical illness incidence
rates following advances in diagnosis. There is a risk that such trends / changes are not correctly
allowed for.

If mortality and/or morbidity is overestimated, then the product will be over-priced and there will
be a risk of not selling the product. If mortality and/or morbidity is underestimated, then the
product will be under-priced and there will be a risk of making a loss, or eventually facing solvency
problems if the new product becomes a major part of the portfolio. Of the two, underestimating
will be more problematic than overestimating.

Associated with the parameter risk is the risk of anti-selection if the insurance company does not
price by splitting policyholders into reasonably homogeneous groups with respect to mortality
and morbidity.

There is also the risk of random fluctuations – even if the estimates of mortality / morbidity are
spot on, claims would be expected to fluctuate around the expected level. The extent to which
claims vary from expected will depend on the size of the portfolio.

Expenses

There is the risk that the contracts sold will not cover the associated expenses. This could come
about in various different ways.

First, the insurance company will not know the expenses involved with this contract. They should
be very similar to those for similar contracts – for example, the current range of critical illness
insurance contracts. But there will be some differences, for example, it will be necessary to
incorporate some checks that the potential policyholders are house-owners, so the underwriting
might be slightly more involved.

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Secondly, future expense inflation might be underestimated.

Thirdly, there is a risk of selling insufficient levels of the contract to recover the development
costs, or to make a sufficient contribution to the insurance company’s overheads.

Finally, the price structure might involve cross-subsidy of (say) small policies by large policies,
otherwise small policies could prove uncompetitive. In this case, there is the risk that the
insurance company sells a greater than expected proportion of small policies, and that overall the
contribution to overheads is insufficient.

Persistency

There are two completely different risks here.

First, if most of these policyholders will have mortgages, then in the event of economic recession
they may be especially hard hit, and may be even more likely than other critical illness insurance
policyholders to lapse their policies (if legislation does not oblige them to have such policies in
respect of their mortgage).

The extent to which this is true will depend on the average wealth of house owners with
mortgages, compared with the wealth of the remaining population of critical illness insurance
policyholders.

Secondly, there is the risk that a large number of existing accelerated critical illness insurance
policyholders who are house owners will be better off lapsing their current policies and taking out
new policies under this tax-efficient format.

(b) Possible solutions to the risks

Mortality and morbidity

To minimise the risk of modelling or parameterising mortality and morbidity risks incorrectly, the
insurance company will need to study the experience of its related contracts. Existing accelerated
critical illness and stand-alone critical illness insurance should be a good starting point.

Reinsurers’ and industry statistics will also be a useful point of reference, especially for unusual
illnesses and more extreme ages.

The risk of pricing on the wrong mortality / morbidity basis could be reduced by offering the
contract as a reviewable premium product, rather than a guaranteed premium product.

The insurance company should use (at least) all of the rating factors that most of the competition
use (eg age, gender, smoker/non-smoker, medical).

The insurance company will need to ensure that the policyholders undergo underwriting at least
as strict as that used for the policyholders underlying the mortality / morbidity data above.
Alternatively the mortality / morbidity ‘advantage’ of belonging to the socio-economic group
‘house-owners’ might be deemed sufficient to compensate for a weakening of the underwriting
procedures, eg a raising of the sums insured at which detailed medical evidence is required.

Quota share reinsurance could be taken out to reduce the financial impact of parameter error.

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To deal with the risk of random fluctuations, the insurance company could use individual surplus
or aggregate excess of loss reinsurance. The extent of reinsurance required will depend on the
insurance company’s total portfolio of similar policies, its free assets and the extent to which
smooth financial results are desirable (eg more important for a proprietary than for a mutual
company).

An alternative to this would be to set up a claim fluctuations reserve, but this would require a
certain amount of capital.

Persistency

The insurance company could tackle the risk of low persistency on this product by setting
premiums assuming a high withdrawal basis, although the extent to which the insurance company
can do this is constrained by competition.

A commission structure to sales agents that shifts remuneration from initial to renewal
commission may make it less likely that the agents sell the product to people for whom it is not
very suitable.

The second problem, of lapse and re-entry on current products, could be tackled in various ways.

One way would be to offer to reclassify eligible policies, charging an appropriate administration
fee. However, a realistic fee might be so high that it still leaves lapse and re-entry as the
preferable option to most policyholders.

Another possibility would be to quantify what addition to benefit (or reduction in premiums)
would equate to the expected cost of administering a large number of lapses and re-entries, and
offering some portion of such an increase as an incentive to continue with the policy in the
existing format.

Expenses

The risk of underestimating expenses could be reduced by making it a reviewable premium

contract.

The risk of insufficient sales could be reduced by aggressive marketing, and a competitive pricing
basis.

The aim is to maximise the total expense contribution plus profit, which will be equal to:

{number of sales} × {expense contribution and profit per sale}.

This will be almost zero for very high and low premiums, and maximised for some middle-of-the-
range premium – depending on elasticity of demand.

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The risk that a cross-subsidy of small policies by large policies combined with a low proportion of
high-premium sales gives rise to an insufficient contribution to the insurance company’s
overheads could be countered by:
• setting the cross-subsidy such that all policies at least pay their own marginal expenses
• profit testing the new business portfolio on a variety of new business mix assumptions
• market research to ascertain the likely new business mix.

(c) Modification with experience

The insurance company will need to monitor the experience of the contract. Such monitoring will
include looking at:
• the composition of new business by age, gender, premium level
• mortality / morbidity experience from mortality / morbidity investigations
• persistency experience from persistency investigations
• expense experience for the product
• embedded value analysis of movement
• analysis of valuation surplus.

In the light of this experience, the actuary will then check that the pricing assumptions for the
contract are adequate. If they are not (or if they were too conservative) then the contract will be
repriced.

This could include altering, if necessary, the balance between fixed and ‘percentage of premium’
expenses in the price structure, depending on the actual composition of new business.

If persistency experience is particularly poor for any group of policyholders (eg all in one area, or
from one seller) then some further investigation would be warranted to determine the real
reason.

The insurance company should also be monitoring the persistency experience of related contracts
to guard against the lapse and re-entry issue. If this looks like it is becoming a problem, then the
insurance company might adopt one of the measures outlined above.

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 Page 32 SP1-30: Problem solving

4.1 Conclusion
The solution above has:
• used the actuarial control cycle to structure the answer
• considered the context of the problem (the general business environment)
• used the specify the problem stage to identify potential risks to the insurance company’s
aims, and how they might arise in the particular situation
• used the develop the solution stage of the cycle to identify possible solutions, and how
they would apply in this situation
• used the last stage of the cycle to think about how to monitor experience
• looked at the risks and solutions earlier to see how that experience will allow the
approach to be modified.

Note how useful the control cycle is as a way of generating the various aspects to consider.

© IFE: 2019 Examinations The Actuarial Education Company

 SP1-30: Problem solving Page 33

Chapter 30 Practice Questions

30.1 An insurance company has a large and established portfolio of immediate needs long-term care
Exam style annuities currently in payment. In return for a single premium based on the expected mortality
experience of the policyholder at the date the annuity payments start, these policies pay an
index-linked benefit.

To be eligible to take out a policy, applicants must have a medically certified need for long-term
care, based on criteria of activities of daily living (ADLs). Two levels of need are identified: ‘Level
1’ is where the policyholder requires only non-nursing, residential home care, and ‘Level 2’ is
where full nursing residential home care is required.

Policyholders who satisfy the criteria for nursing home care at outset receive 175% of the benefit
level received by those who only meet the lower care level criteria. However, benefit levels
cannot be changed once payouts have commenced, except for the automatic index-linked
increases promised under the policy.

The insurance company now proposes launching a third variant of the policy. This will provide the
lower benefit level initially to applicants who satisfy the less stringent ADL criteria, but will also
give the policyholder the right to apply for the enhanced benefit level at any subsequent time,
subject to then meeting the additional ADL criteria required but for no extra cost at the time of
benefit increase.

(i) Explain how, if at all, the mortality assumptions that will be used for pricing the existing
product types may alter if the proposal goes ahead. [2]

(ii) Discuss how the mortality assumptions for pricing the new variant of the product are
likely to compare with those used for the existing products. [3]

(iii) Discuss how the premiums charged for the three types of policy in the future are likely to
compare with each other, and with those charged for the existing policy types before the
new product launch. [5]

(iv) Describe the investigations that the insurance company might undertake in order to help
determine appropriate mortality assumptions for pricing the new variant of policy, and
explain how the assumptions would be determined. [10]
[Total 20]

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 Page 34 SP1-30: Problem solving

30.2 An insurance company issues a wide range of conventional and unit-linked long-term health and
care insurance policies.
Exam style

(i) Explain how each of model error, parameter error and random fluctuations can lead to
losses from morbidity experience, in each case giving a simple example of how this can
arise. [3]

(ii) (a) Suggest how the actuarial control cycle can help the company to monitor and so
manage any problem that it may have with its morbidity experience.

(b) Suggest and briefly describe the various steps that the insurance company could
take to manage any problem that it may have with regard to its morbidity
experience. [10]
[Total 13]

© IFE: 2019 Examinations The Actuarial Education Company

 SP1-30: Problem solving Page 35

Chapter 30 Solutions
30.1 For convenience, the level 1 policy that has the option to increase to level 2 will be referred to as
the “enhanced level 1 policy”, and the level 1 policy without the option will be called the “normal
level 1 policy”.

(i) Effect on mortality assumptions for normal level 1 and level 2 policies

The mortality assumption for level 2 policies should be unchanged from before. [½]

Applicants for normal level 1 policies will now be more selective than before, ... [½]

... ie those who don’t expect to remain at level 1 for a significant time will be more likely to
purchase the enhanced level 1 policy instead. [½]

Assuming that level 1 annuitants generally experience lighter mortality than those at level 2, then
it is likely that lower mortality rates will need to be assumed for the normal level 1 applicants
than previously. [½]
[Total 2]

(ii) Mortality assumptions for the new enhanced level 1 policies

For these policies, two different mortality assumptions will be needed: one to apply to
policyholders while (and only while) they qualify for level 1 benefits, the other to apply from when
they first qualify for level 2 benefits. [1]

Under normal level 1 policies, the mortality assumption represents an average of these two
mortality bases, ... [½]

... weighted by the expected proportions of policyholders in the two health classes in each future
policy year. [½]

So the mortality that should be assumed here for policyholders while receiving level 1 benefits
will be lighter than previously assumed for this benefit level (all else being equal). [½]

Once policyholders have transferred to level 2, it should be reasonable to assume that they would
have the same mortality as annuitants who originally take out their annuities at level 2, for the
same risk classification group. [½]

On the other hand, it might be argued that enhanced level 1 annuitants would apply as quickly as
possible for transfer to level 2, to maximise benefit payments, ... [½]

... which might mean that slightly lower mortality assumptions might be appropriate at level 2
compared with normal level 2 entrants. [½]
[Maximum 3]

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Page 36 SP1-30: Problem solving

(iii) Effect on premium rates

How the premiums for the different levels compare with each other

The single premium for the enhanced level 1 policies will be higher than for normal level 1,
because in each future policy year an assumed proportion of policyholders will transfer to higher
benefit levels, whereas under normal level 1 policies they receive the lower level of benefit at all
times. [1]

However, this product will also tend to attract more people who think they are likely to require
full nursing care in the future. [½]

This will tend to increase further the premium charged for the enhanced level 1 policies. [½]

There remains the issue of how the level 2 policy premiums compare with those of the others. [½]

It is not clear whether these should be higher or lower than the level 1 premiums, because
although someone buying in at level 2 will receive higher average annual payments, the benefits
will be received for a shorter period. This is again assuming that level 2 mortality is higher than
level 1. [½]

So it will depend on how much worse level 2 mortality is than level 1 mortality. [½]

How the new premiums compare with the existing ones

The single premium for normal level 1 policies is likely to be higher than before, on average,
because of the generally lower mortality assumptions. [½]

The single premium for level 2 policies is expected to be unchanged (except for any beneficial
effect from expense assumptions – see below). [½]

As well as the above changes to mortality, there should be some reduction in the expense
assumptions from previously. [½]

This is because the insurance company will be expecting to sell significantly higher volumes of
business overall as a result of the change, spreading the overhead costs over more policies. [½]

This will reduce all the single premiums compared with the above. [½]

The above will also be affected by the competition in the market. The new enhanced level 1
policy will need to be seen as significantly attractive in the market, to offset the increase in price
compared with the normal level 1 benefit type. [½]
[Maximum 5]

(iv) Obtaining the new pricing assumptions

Level 2 annuity rate mortality

The insurance company would investigate the mortality experience under its existing level 2
policyholders. [½]

© IFE: 2019 Examinations The Actuarial Education Company

SP1-30: Problem solving Page 37

The most recent experience would be chosen, with a long enough investigation period to produce
a credible volume of data in each cell. [½]

Cells would be created by subdividing the data into homogeneous groups, by age, gender, policy
duration, and by smoker status. [½]

Other health-related factors such as medical history, family history, and results of the ADL
assessments should be considered, ... [½]

... as this information will also be used by the company when assessing the risk of each individual
applicant. [½]

Other factors, eg territory, sales channel and location might also be investigated. [½]

The actual deaths occurring in each cell would be compared with those expected according to
some standard mortality basis. [½]

This might be the mortality assumptions in the original pricing basis, or a relevant standard
mortality table (which may be appropriately broken down by the major risk classification factors).
[½]

This will enable the insurance company to estimate its recent experience rates. The future
mortality experience will be projected, allowing for: [½]
• any possible improvement in mortality in future [½]
• the effect of any future changes to underwriting and risk classification procedures. [½]

The mortality projection will incorporate the extrapolation of any recent trends in the experience
that are expected to continue in the future. [½]

The insurance company will try to identify these trends, both by looking at its own experience
over a longer time period, … [½]

… and also by looking at any relevant industry and population mortality data. [½]

Finally a margin may be included in the basis (assume lower mortality than best estimate) to take
account of the uncertainty involved in setting the assumption. [½]

Level 1 annuity rate mortality

The existing level 1 policyholder data could be analysed in the same way as level 2. [½]

However, the experience data could not be used without significant adjustment, because now the
insurance company must only include policyholders in the exposed to risk while they do not
qualify for the enhanced benefit level. [½]

This will be difficult to assess. The insurance company could group its data according to the
actual level of care to which each level 1 policyholder would have been entitled. [½]

This may be possible if the insurance company has kept historical address records of all its
policyholders, so that a change in status could be apparent from the date the address changes,
eg from a residential home to a nursing home. [½]

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 Page 38 SP1-30: Problem solving

This could be a very laborious process, and would be fraught with errors. [½]

A possible alternative might be to group the data by policy duration, recognising that the
proportion of policyholders eligible for level 2 benefits should increase steadily with increasing
duration of the annuity. The mortality assumption might then be based only on the experience of
policyholders within the first few years of entry, although this would be an approximation.
[1 for any sensible suggestion]

In practice it might be possible to make use of standard industry mortality tables that are suitably
split (eg according to ADL levels). [½]

Because of this uncertainty, the company would probably be quite prudent in the first instance,
assuming lighter mortality than it might have done otherwise. [½]

It will be imperative to monitor closely the emerging experience under the enhanced level 1
policyholders, ... [½]

... and to update the pricing basis as the new experience emerges. [½]
[Maximum 10]

30.2 (i) Model, parameter and random fluctuations risk

Model error

This occurs when the insurance company incurs losses due to error in the specification (structure)
of the model of the sickness process that has been used. [½]

For example, the insurance company might have priced its IP insurance contracts using the claim
inception and annuity method, which is not a fully realistic approach. The approximations
involved may have led to the premiums being too low. [½]

The use of a more realistic model (eg multiple-state model) could have led to fewer losses, even
where the same data were used to estimate the models’ parameters. [½]

Parameter error

This is where the insurance company incurs losses as a result of incorrect parameter values being
used in its morbidity model. [½]

For example, when pricing a critical illness contract, the insurance company may have assumed
critical illness incidence rates at each age that were lower than the actual probabilities of claiming
in the insured population. [½]

Random fluctuations error

This is where the insurance company incurs losses due to random fluctuations, even though it
might have used an appropriate morbidity model and correct parameter values. [½]

© IFE: 2019 Examinations The Actuarial Education Company

SP1-30: Problem solving Page 39

For example, a portfolio of critical illness contracts, whose expected critical illness rates were
equal to the pricing model’s parameters, could still by chance have more critical illness claims
than expected over a particular time period. [½]
[Maximum 3]

(ii)(a) Use of the actuarial control cycle

The extent of any problem can be identified by monitoring the experience. [½]

The actual experience rates should be compared with those expected according to the relevant
premium and/or reserving basis. [½]

An analysis of surplus will be performed. [½]

This will quantify the amount of loss actually incurred as a result of the morbidity experience,
separately from other sources of profit or loss. [½]

This will put the morbidity losses into context and will help establish whether the losses are of a
sufficient magnitude to justify taking further action. [½]

For this purpose it is important to ascertain whether or not the losses have been consistent over
time, for example by looking at past trends. [½]

Revised assumptions can be fed back into the insurance company’s decision-making procedures,
for example: [½]
• into the pricing basis, ... [½]
... leading to a revision of prices and/or charges to reduce the risk of losses on future new
business (and on existing business, if the charges and/or premiums under existing
contracts are reviewable) [½]
• into the reserving basis, ... [½]
... which will prevent the over-distribution of profit to the providers of capital, and hence
help to protect the solvency of the existing business [½]
• into the insurance company’s risk management and decision-making models, ... [½]
... for example in calculating the probability of ruin when determining reinsurance policy,
which will then help to ensure that appropriate levels of risk control (reinsurance) are
bought. [½]

(ii)(b) Other methods of managing the morbidity risk

The underwriting strategy could be changed. [½]

An inconsistency between the morbidity rates implied by the underwriting strategy and those
used in the insurance company’s standard rates of premium could be a significant contributor to
risk. [½]

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Page 40 SP1-30: Problem solving

Claims control procedures could be improved, … [½]

… eg the sickness status of claimants could be reassessed and recertified more frequently, or
perhaps more objectively or independently, in order to stay within the expected experience. [½]

Rehabilitation and counselling services could be introduced if this was cost effective (ie the cost
of providing the services was less than the cost of claims saved). [½]

In the longer term, could change the product design. For example: [½]
• change policy wording (definition of claim) [½]
• introduce partial return to work benefit [½]
• reduce guarantees and options [½]
• introduce price / charges review facility [½]
• shorten the contractual linked-claims period [½]
• change from without-profits to unit-linked designs. [½]

More focused selling on the basis of financial need could improve morbidity rates, by reducing the
levels of lapse rates and so reducing the impact of selective withdrawal against the insurance
company. [½]

The reinsurance strategy could be revised. A surplus reinsurance treaty on an original terms or
risk premium basis may be appropriate. [½]
[Maximum 10]

© IFE: 2019 Examinations The Actuarial Education Company

SP1-30: Problem solving Page 41

End of Part 6

What next?
1. Briefly review the key areas of Part 6 and/or re-read the summaries at the end of
Chapters 28 to 30.
2. Ensure you have attempted some of the Practice Questions at the end of each chapter in
Part 6. If you don’t have time to do them all, you could save the remainder for use as part
of your revision.
3. Attempt Assignment X6.

Time to consider …
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surveys have found that students who do a mock exam of some form have significantly higher
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You can find lots more information on our website at www.ActEd.co.uk.

Buy online at www.ActEd.co.uk/estore

And finally ...

Good luck!

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Unless prior authority is granted by ActEd, you may not hire

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is not used or copied by anybody else.

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 SP1: Assignment X1 Questions Page 1

X1.1 Define the following terms that may apply to critical illness insurance:
(a) assessment period
(b) permanent
(c) irreversible
(d) total permanent disablement
(e) terminal illness. [5]

X1.2 Discuss the following two ways in which a private medical insurance provider might seek to
control the costs of claims:
(a) pre-authorisation
(b) preferred provider agreements. [5]

X1.3 A health and care insurer currently sells stand-alone critical illness insurance policies with terms
varying from ten to twenty five years. The policies have premiums that are reviewable every five
years. All other terms in the contract are guaranteed for the term of the contract.

It is considering selling a new policy that will allow both of the following to be reviewed every five
years:
• the insured events
• the level of the premiums.

(i) Explain the problems with the existing design to the insurer. [2]

(ii) Discuss whether policyholders are likely to welcome this change and suggest how the
insurer can ensure the changes are viewed well. [3]
[Total 5]

X1.4 The following events might lead to personal financial loss or hardship:
A Payment of expenses for medical care where a person’s home country has poor public
health facilities.
B The occurrence of sickness or disability after retirement age.

(i) Describe the ways in which each event can lead to hardship and indicate the range of
persons who may be directly, or indirectly, affected. [3]

(ii) Describe, with reasons, a suitable health insurance product that may be purchased in
order to alleviate or prevent the hardship arising from each event and state whether the
product is likely to be traditional non-profit, unit-linked and/or inflation proofed. [4]
[Total 7]

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 Page 2 SP1: Assignment X1 Questions

X1.5 Janet and John, who are both in their 20’s, were recently married and are meeting an insurance
broker to discuss their financial plans. John is self-employed so has no employee benefits. He
earns £30,000 pa. Janet works for a financial institution which has an employee benefit package
that includes a short-term sick pay scheme and a group income protection plan. She earns
£24,000 pa.

John is considering the following income protection policy:

Type: Individual income protection policy

Deferred period: Three months
Definition of disability: Unable to follow own occupation
Benefit amount: £1,000 per month
Benefit term: Benefit is paid from the end of the deferred period for a maximum of 5
years
Expiry age: 60th birthday

Janet is currently a member of her employer’s benefit package. The benefits are:

Type: Short-term sick pay plan

Deferred period: None
Definition of disability: Unable to follow own occupation
Benefit amount: 100% of salary for 2 months, 75% of salary for the next 4 months
Expiry age: 65th birthday

Type: Group income protection policy

Deferred period: Six months
Definition of disability: Unable to follow own occupation
Benefit amount: 60% of pre-disability salary
Benefit increase: 3% on the anniversary of the income protection benefit becoming payable
Expiry age: 65th birthday

Calculate what employee and insurance benefits would be payable if Janet and John were both
injured in a road traffic accident and were unable to work for six years. You should ignore the
effect of any income tax that might be payable. You should set out your answer showing the
benefits paid in each of the years. [7]

X1.6 A long-term health insurer sells both group and individual health insurance contracts.

(i) Explain the differences between the group contracts and the individual contracts provided
by this insurer. [5]

(ii) Describe the advantages and disadvantages to an individual of joining a group insurance
scheme rather than buying an individual policy. [2]
[Total 7]

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 SP1: Assignment X1 Questions Page 3

X1.7 You are part of a team which is designing a pre-funded long-term care insurance plan which is to
compete with a number of existing market products. You have been asked to produce a
comparison of the benefit structure of the existing plans in the market.

List the features that you would need to consider and suggest appropriate values for these, where
relevant. [8]

X1.8 You are a product actuary within a health and care insurer, which is reviewing its income
protection business.

(i) Describe how a policyholder’s occupation may be relevant in an individual income

protection contract. [5]

(ii) Describe the types of guarantee that might be provided on individual income protection
contracts. [5]
[Total 10]

X1.9 (i) Describe the employer’s interests as a stakeholder in the design of a group income
protection insurance product. [5]

(ii) Explain why employers have a stakeholder interest in the design of a group private
medical insurance product, but rarely in the design of group critical illness insurance
products. [4]

(iii) Suggest reasons why group long-term care insurance is unlikely to exist. [1]
[Total 10]

X1.10 An insurer is proposing to launch a physiotherapy cash plan for sportspeople on an individual
basis.

Describe and explain a possible design for the policy including:

• the benefits that might be provided
• the policy conditions for claiming
• the underwriting procedures that might be used
• the premium rating structure
• the use of incentives to encourage the renewal of policies.

You are not required to suggest a pricing basis or discuss how premiums might be calculated. [16]

END OF PAPER

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All study material produced by ActEd is copyright and is sold
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 SP1: Assignment X3 Questions Page 3

X3.2 (i) Explain why it is important to incorporate persistency into product pricing. [4]

(ii) Describe how a change of distribution channel might affect persistency rates. [3]

It has been suggested that, rather than analysing its own experience, a health and care insurer
should use industry statistics to estimate persistency appropriately for pricing future product
launches.

A particular health and care insurer is considering using industry-average sickness rates for pricing
a new IP insurance contract.

The data set was collected over a period of three years, ending two years ago.

(iii) Discuss the issues it would face in using this source of data. [5]
[Total 12]

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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.

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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.

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SP1: Assignment X3 Solutions Page 3

Solution X3.2

The material for this question is covered in Chapter 13, Assumptions (1) – General considerations.

(i) Why persistency is an important component of product pricing

Long-term contracts

If a health and care insurance company pays a benefit upon surrender that is higher than asset
share, the company will make a loss on that individual policy. [½]

The same will happen on policies that pay no surrender benefit where asset shares are negative
… [½]

… which will normally be true at early policy durations when lapse rates also tend to be
highest. [½]

Similarly, paying a benefit which is less than asset share will give rise to a profit. [½]

Persistency is also important for projecting future in-force volumes. For example, lower
persistency rates would mean that less profit would be expected from the portfolio later in the
policy term, as fewer policies would still be in force. [½]

Short-term contracts

Renewal rates are needed in order to assess the extent to which initial expenses can be spread
over subsequent renewals. [½]

The lower the renewal rate, the fewer renewals are expected from each policy sold, and so the
higher the premium loading for initial expenses needs to be. [½]

All types

The impact on volume will affect the spreading of overhead expenses, and also of any fixed
one-off expenses such as those for product development. [½]

Poor rates of persistency may also lead to reduced profits as a result of excessive levels of
commission being paid, eg if indemnity commission is used. [½]

This will be less of an issue if appropriate commission clawback arrangements are in place. [½]

Withdrawals can be selective, taking out the healthy individuals from the portfolio and leaving the
remaining policies subject to higher claim experience than was originally expected. [½]

The pricing morbidity assumptions must take account of the expected effect of these selective
withdrawals. [½]

If persistency is incorrectly allowed for in the company’s pricing models, this would give a
misleading indication of the profitability of the contract. [½]

This could also affect competitiveness and hence sales volumes. [½]
[Maximum 4]

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Page 4 SP1: Assignment X3 Solutions

(ii) The effect of changing distribution channel on persistency

A change in who initiates the sale can affect persistency rates. [½]

Persistency rates are likely to be higher if the client initiates the sale. [½]

The sales practice may be different, for example: [½]

• where clients have been put under more sales pressure to buy a policy or to take a larger
policy, then lapse rates are likely to be higher than where sales have been more strictly
based on need [1]
• sales of policies made without proper information being gathered about the client’s
needs, can lead to inappropriate policies being sold through ignorance. [½]

Poor sales practices might particularly be the case where the intermediary’s rewards are largely
based on initial commissions, rather than renewal or level commissions. [½]

Different levels of financial sophistication of the client base can lead to different perceptions of
the value of a contract, and could lead to different persistency rates. [½]

Different target markets may encompass different levels of affluence and economic prosperity.
There may then be differences in withdrawals that arise through economic hardship. [½]
[Maximum 3]

(iii) Issues faced in using industry data

The insurer would seek to adjust the data in forming its assumptions, but there will be many
factors that it will not be able to allow for with certainty. [½]

There could be differences in the expected experience due to differences in:

• lapse rates:
– distribution channel [½]
– levels of commission paid / commission clawback arrangements [½]
– quality of after-sales service [½]
• sickness rates:
– initial underwriting or claims control [½]
– definition of sickness [½]
• both lapse and sickness rates:
– target market [½]
– products or product features, eg the maximum proportion of pre-sickness income
payable for sickness rates. [½]

Industry data will be a heterogeneous mix of the above factors, and the great variation in
experience between the different companies will make the industry average a very poor indicator
of the expected experience for any individual company. [½]

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SP1: Assignment X3 Solutions Page 5

Other reasons why the industry data may not be appropriate for use by a given insurer:
• the data may be inaccurate, ... [½]
... incomplete ... [½]
... or otherwise unrepresentative of the market as a whole [½]
• there may not be sufficient data for credibility, although this is much less likely with
industry data than it is for a single insurer [½]
• the data may not be in the correct format [½]
• the data may be unavailable [½]
• industry experience may have changed in the period since the data were collected, ... [½]
... or be expected to change in future, eg the data may have been collected during a
recession when persistency was low. [½]

The effect of heterogeneity in the industry data can also give rise to spurious trends in experience
observed over time, through changes in the mix of companies that comprise the industry
statistics. [½]

Additionally, as this is a new product, the insurer will not have any data of its own with which to
check the above points. [½]
[Maximum 5]

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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.

The Actuarial Education Company © IFE: 2019 Examinations

 SP1: Assignment X4 Questions Page 1

X4.1 A health and care insurer has been using the inception / disabled life annuity approach for
modelling and pricing its income protection business since it was launched many years ago.

(i) Describe the inception / disabled life annuity approach. [3]

In the health insurer’s most recent board meeting, one of the board members questioned the
ongoing appropriateness of the current modelling approach arguing that it is too simplistic. He
believes that given the maturity of the income protection business, the multi-state modelling
approach should enable more granular and accurate analyses to be produced.

(ii) Describe the main differences between the multi-state modelling approach and the
inception / disabled life annuity approach. [5]
[Total 8]

The Actuarial Education Company © IFE: 2019 Examinations

 Page 2 SP1: Assignment X4 Questions

X4.6 A health insurance company sells a conventional regular premium pre-funded long-term care
product where the benefits are regular payments that are dependent on the severity of the
impairment.

(i) Describe the different types of reserve that might be held for this product. [4]

(ii) Describe the approaches that this insurer can take to calculate claims reserves and
suggest the circumstances in which it would use each. [6]

The health insurer has recently calculated its embedded value, but has now decided that its future
new business volumes are likely to be lower than expected following changes just announced by
the State regarding long-term care.

(iii) Explain how the lower than expected future new business volumes might impact the
current and future embedded value of the insurer. [3]
[Maximum 13]

© IFE: 2019 Examinations The Actuarial Education Company

SP1: Assignment X4 Solutions Page 3

Solution X4.1

The method of pricing income protection insurance is covered in Chapter 17, Pricing (1) –
Individual business. Chapter 11, Modelling, contains more general information on multiple-state
modelling, which is also useful for part (ii).

This question is taken from Subject ST1, September 2017, Question 2(i)(ii).

(i) Inception / disabled life annuity approach

An inception / disabled life annuity approach considers two functions, namely the claim inception
rate and the disabled life annuity. [½]

It ignores recoveries and future sickness. [½]

The ‘claim inception rate’ is the probability that a claim will become payable to an individual in
the year of age x to x + 1, for a given deferred period. [½]

The individual will have become sick and remained so until the end of the given deferred period
for the benefit payment to commence. [½]

‘Claim inception rates’ are derived from ‘sickness inception rates’ by multiplying the probability of
sickness inception by the probability of remaining sick throughout the deferred period. [½]

The ‘disabled life annuity’ is the present value at the date of claim inception of expected claim
payments to individuals disabled after the deferred period until policy expiry. [½]

Allowance is made for any escalation of the claim amount, interest and the probabilities of death
and recovery between the end of the deferred period and expiry date. [½]

Within the cashflow program, the claims outgo in any period is taken as the lump sum value of
the benefit (annual benefit amount x disabled life annuity) multiplied by the probability of
becoming eligible for claim (claim inception rate). [½]

Cashflows should be discounted back to the policy inception date and the calculation needs to be
carried out for all possible years of cover. [½]
[Maximum 3]

(ii) Difference with the multi-state approach

General modelling
Under the multi-state modelling approach, policyholders are separately tracked through the
various stages of ‘healthy’ and ‘claiming’: [½]
• healthy premium payers [¼]
• lives falling sick within deferred period [¼]
• lives becoming claimants following deferred period [¼]
• lives recovering, reverting to premium payers [¼]
• lives dying. [¼]

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Page 4 SP1: Assignment X4 Solutions

Each subclass will have its own set of transition probabilities: [½]
• sickness inception [¼]
• lapse [¼]
• mortality [¼]
• recovery [¼]
• policy expiry. [¼]

Depending on the sophistication of the model, probabilities may vary according to the number of
previous times that the cohort has been ill and all transition rates may be a function of the
duration within that stage. [½]

The multi-state approach therefore requires a more granular level of data to be available for
setting the various assumptions than the inception / disability annuity approach. [½]

The actuary needs to recognise that the available data may not permit this degree of
sophistication of the method in practice. [½]

Pricing

Pricing using a multiple-state modelling approach requires determination of the proportion of

lives in each state, using the relevant duration-based intensities. [½]

The specific rates required for the multi-state model are unlikely to be tabulated. [½]

Whereas for the claim inception / disability annuity approach these rates may be readily available.
[½]

The value of claims outgo will thus depend on the number of lives within (one of) the benefit-
receiving sub-cohorts, in a given month, multiplied by the relevant average sum insured. [½]

Against the claims outgo will be balanced: the premium coming from those in a premium-paying
state, plus the investment income, less all relevant expenses and other outgoings in the
appropriate month. [½]

Transition intensities will be applied to each status to determine the numbers appropriate to
various cells for the next month. [½]

In theory, the model could be very complex, with hundreds of sub-cohorts open at any time. [½]

In practice, the lack of detailed statistics to estimate all of the transition intensities and the
avoidance of spurious accuracy will necessitate a more straightforward and meaningful approach,
… [½]

… such as the combination of various sub-cohorts and reduction of number of transition

intensities required. [½]

Even with these approximations, the multi-state model will provide more insight into the
robustness of any rating and reserving structure … [½]

© IFE: 2019 Examinations The Actuarial Education Company

SP1: Assignment X4 Solutions Page 5

… and allow sensitivity testing to be performed. [½]

The latter is more difficult with the inception / disabled life annuity approach. [½]

A multi-state approach can also allow more complex features to be modelled, such as linked or
proportionate claims. [½]
[Maximum 5]

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SP1: Assignment X4 Solutions Page 9

Solution X4.3

Options are covered in Chapter 20, Pricing (4) – Options and guarantees, and setting reserves is
covered in Chapter 22, Approaches to setting reserves and solvency capital requirements.

General considerations

The method and assumptions depend on the purpose of the reserving exercise. [½]

For example, for statutory or solvency purposes a prudent approach is likely to be taken (by
calculating prudent reserves and/or by holding solvency capital), ... [½]

... whereas for internal purposes a best estimate approach may be more appropriate. [½]

Details about the premium rates of the policies taken up under the option are needed. [½]

Insurability will usually be guaranteed at the company's standard premium rates at the time of
extension. [½]

If the extension premiums are on guaranteed terms rather than the standard rates then in force,
this poses an extra risk to the insurer since it is bound by these rates for the extended term. [½]

The extent of the option should be considered, eg whether the policies taken up under the option
have options to extend again at the end of the new term. If so, the risks are compounded and
further assumptions are needed for the second extension. [1]

Considerations when setting assumptions

Mortality / morbidity options are normally valued using cashflow projections. [½]

The total expected additional costs of an option depend on the health status of those that choose
to exercise the option, and the proportion of lives that choose to exercise the option. [½]

More specifically, valuing a mortality / morbidity option requires the following extra assumptions:
• the probability that the option will be exercised, at each possible exercise date [½]
• the additional benefit level that will be chosen, if this is at the discretion of the
policyholder [½]
• the expected mortality / morbidity of the lives who choose to exercise the option [½]
• the expected mortality / morbidity of the lives who choose not to exercise the option [½]
• any additional expenses relating to the option. [½]

Probability that the option will be exercised and the additional benefit level that will be chosen

The choice as to whether to exercise the option depends heavily on the self-perceived health of
the policyholder. [½]

A policyholder who perceives himself/herself to be in poor health or more susceptible to illness is

more likely to exercise the option, thus selecting against the insurer. [½]

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Page 10 SP1: Assignment X4 Solutions

The desirability of the option also depends on the financial needs of the policyholder at the option
date, ... [½]

... eg the policyholder may no longer have a desire for cover in the event of diagnosis of a critical
illness, and so opts not to extend it despite it being ‘a good deal’. [½]

If prudence is required, the proportion choosing to extend would be overstated. [½]

Therefore the model may assume that all eligible policyholders will take up the option, … [½]

… and that the maximum additional benefit will always be taken. [½]

If there are many possible dates on which an option may be exercised, or there is a choice from
several alternative options, the model may assume that the worst option from the financial point
of view of the company is chosen with probability one. [½]

Alternatively, the model may use more sophisticated take-up rate assumptions which vary by
exercise date or by alternative option. These would ideally be based on past experience. [½]

Expected mortality / morbidity of the lives who choose to exercise / not exercise the option

Assumptions will also be needed for the morbidity and mortality experience during the original
term, ... [½]

... and of those policyholders who choose to extend cover thereafter. [½]

The experience, split by age, gender etc, would be analysed ... [½]

... and allowance made for any trends and margins when projecting future morbidity / mortality.
[½]

To reflect the anti-selection opportunity, a much higher claim incidence rate assumption would be
made for post-option experience. [½]

For example, the mortality / morbidity of those who exercise the option may be:
• assumed to be a higher percentage of the base mortality / morbidity table, eg 120% of
standard rates [½]
• age loaded, eg a policyholder of age x may be assumed to experience mortality of age
x + 5 years. [½]

Alternatively, it may be assumed that the mortality / morbidity experience of those who take up
the option will be the ultimate experience which corresponds to the select experience that would
have been used as a basis if underwriting had been completed as normal when the option was
exercised. [½]

Assumptions would ideally be based on post-option past data, if available. [½]

Note that there should be a link between the assumed option take-up rates and the assumed
mortality / morbidity rates. [½]

© IFE: 2019 Examinations The Actuarial Education Company

SP1: Assignment X4 Solutions Page 11

For example:
• In general, the smaller the proportion that exercises the option, the worse will be the
subsequent mortality / morbidity experience of those exercising the option. If a
substantial proportion exercises the option, then their subsequent mortality / morbidity
experience will on average be less extreme. [½]
• An assumption that option-takers experience Ultimate mortality / morbidity would be
consistent with an assumption that all eligible policyholders take up the option. [½]
• It may be assumed that the lives who do not take up the option will continue to
experience the same level of mortality as would have been assumed without the
existence of the option. However, this would mean that the average mortality for all lives
has been assumed to be in excess of the base mortality / morbidity assumption. [½]
• It may be assumed that the mortality / morbidity of those who do not take up the option
is such that average mortality / morbidity for all lives remains at the base expected level.
The assumed mortality of those who do not take up the option would then be lower than
this base level. [½]

The assumptions used in the valuation of the option should be consistent with those used to value
the guaranteed benefits and the assets. [½]

The experience on similar options on similar contracts may be useful. [½]

Reinsurers may be able to offer some assistance in setting assumptions. [½]

[Maximum 11]

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SP1: Assignment X4 Solutions Page 17

Solution X4.6

Types of reserves and embedded value are discussed in Chapter 21. Setting reserves is discussed in
Chapter 22, Approaches to setting reserves and solvency capital requirements..

(i) Types of reserve

For each in-force policy the insurer should hold the expected present value of future claim
inceptions … [½]

… allowing for different benefits provided in different states of impairment... [½]

... plus the expected present value of future expenses (both regular and claim) ... [½]

... less the expected present value of the future premiums ... [½]

... plus the expected cost of any options. [½]

For each claiming policy, the insurer should hold the current claim annuity value of the benefits in
payment, ... [½]

... again allowing for different benefit levels … [½]

… and for the claimant’s current state of health … [½]

… plus the expected present value of the associated future claim expenses. [½]

Additional reserves may be needed to cover the expected cost of future payments that may be
made for existing policyholders:
• who have reported the need for care but for whom payments have not commenced ... [½]
... this may be because they are still within the deferred period of their policy as at the
valuation date ... [½]
... or because their severity level is still being ascertained [½]
• who are in need of care, but have not yet reported it to the insurer (ie IBNR). [½]

An investment mismatch reserve might also be held, to allow for the extent to which assets do
not match liabilities. [½]
[Maximum 4]

(ii) Approaches to setting reserves

The two approaches that can be taken to calculating the claims reserves are statistical estimates
and case estimates. [½]

Statistical estimates

Claims are assessed altogether in relatively homogenous cohorts, based on historical trends and
patterns ... [½]

... adjusted for any known or anticipated future changes, eg an increase in medical inflation. [½]

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Page 18 SP1: Assignment X4 Solutions

The portfolio might be split by contract type, distribution channel or geographical location. [½]

A statistical distribution is fitted to the past experience, which allows the insurer to estimate the
level of claims incurred given the earned premium in a certain period. [½]

The current claims reserves are calculated applying the relevant earned premium and adjusting
this for any trends in claim incidence or cost. [½]

The calculation of the IBNR reserve can be included in the statistical estimation method if these
claims are included separately in the data. [½]

This may be significant if long-term care claims take time to be reported. [½]

Statistical estimation is often appropriate:

• for homogenous claims [½]
• if the insurer has a large portfolio and it considers the claims experience to be stable [½]
• if the insurer has insufficient data on individual cases to carry out case estimates, or if it is
concerned about the quality of such data [½]
• where benefits are paid as an income (as they are in this case). [½]

Case estimates

For case estimates, an experienced claims manager inspects the claims details and estimates the
ultimate amount of claims for each case individually. [½]

The following factors are likely to be taken into account:

• age and gender of claimant [½]
• residence of claimant, eg own home, residential home [½]
• type of impairment, eg inability to dress oneself or mental impairment [½]
• current duration of claim [½]
• whether the level of impairment is increasing gradually or quickly [½]
• severity of impairment [½]
• recent medical examinations or doctors’ reports on the claimant. [½]

Case estimation is more likely to be used:

• for a small volume of claims [½]
• for unusual claims, eg for very large benefit levels or for unusual types of impairment [½]
• if the information available will allow the insurer to produce a significantly better estimate
of the ultimate claim cost ... [½]
... for example, in this case, where the claims manager is able to make a reasonable
estimate of the duration of each claim. [½]

© IFE: 2019 Examinations The Actuarial Education Company

SP1: Assignment X4 Solutions Page 19

However, case estimation can be time consuming and costly, so the benefits that can be gained in
terms of accuracy of claims reserves would need to be justified. [½]
[Maximum 6]

(iii) Impact of lower NB volumes on current and future EV

Embedded value (EV) is the present value of future shareholder profits in respect of the existing
business of a company, including the release of shareholder-owned net assets. [½]

Current embedded value

Since EV is the value of shareholder profits arising from existing business only, no credit is taken in
respect of profits on future new business. [½]

Hence there is no direct impact on the current embedded value due to lower expected future new
business volumes. [½]

However, lower expected new business volumes are also likely to mean higher per policy
expenses due to the need to spread overheads and fixed expenses over a smaller portfolio. [½]

This could reduce the present value of shareholder profits and hence the current embedded value
(due to the existing business needing to support a greater proportion of these overheads). [½]

Future embedded value

In future, lower new business volumes will lead to lower levels of in-force business and hence
lower present value of future profits. [½]

However, if the product generates new business strain (which is likely), lower new business
volumes would reduce the overall new business strain, … [½]

… increasing the insurer’s net assets. [½]

Overall the likely outcome is that the embedded value will increase more slowly under lower new
business volumes than it would otherwise, assuming that new business is written on profitable
terms. [½]
[Maximum 3]

The Actuarial Education Company © IFE: 2019 Examinations

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.

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SP1: CMP Upgrade 2019/20 Page 1

CMP Upgrade 2019/20

Subject SP1

CMP Upgrade
This CMP Upgrade lists the changes to the Syllabus objectives, Core Reading and the ActEd
material since last year that might realistically affect your chance of success in the exam. It is
produced so that you can manually amend your 2019 CMP to make it suitable for study for the
2020 exams. It includes replacement pages and additional pages where appropriate.
Alternatively, you can buy a full set of up-to-date Course Notes / CMP at a significantly reduced
price if you have previously bought the full-price Course Notes / CMP in this subject. Please see
our 2020 Student Brochure for more details.

This CMP Upgrade contains:

all significant changes to the Syllabus objectives and Core Reading.
additional changes to the ActEd Course Notes and Assignments that will make them
suitable for study for the 2020 exams.

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 Page 2 SP1: CMP Upgrade 2019/20

0 Changes to the Syllabus objectives

There were no significant changes to the Syllabus objectives.

© IFE: 2020 Examinations The Actuarial Education Company

 SP1: CMP Upgrade 2019/20 Page 3

1 Changes to the Core Reading and ActEd material

This section contains all the non-trivial changes to the Core Reading and ActEd material.

Chapter 1
Page 10

The following sentence has been deleted:

The tax treatment of IP insurance premiums and benefits in the UK is covered in detail in
Subject SA1.

Page 13

The first bullet point has been amended to read:

integrate with benefits provided by the policyholder’s employer

Chapter 2
Page 11

The first sentence of the second paragraph has been amended to read:

The word ‘total’ in the definition in practice usually means the failure of ability to perform a
major or substantial part of the job or function.

Chapter 4
Page 8

The first paragraph of Core Reading has been amended to read:

It should be noted that in the USA, the term ‘major medical expenses’ is used to mean a
comprehensive PMI product type offering reimbursement for the costs of primary,
secondary and tertiary care as defined in the policy.

The final sentence of Core Reading has been amended to read:

For a low level of premium, the policyholder and family are entitled to a range of specific
payouts dependent on certain healthcare-related events.

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Page 4 SP1: CMP Upgrade 2019/20

Chapter 6
Page 5

The second sentence of the penultimate paragraph of Core Reading has been amended to read:

Insurance is crucial as, in most countries, State welfare benefits are unlikely to maintain
individuals in the same financial position they were in prior to the onset of illness or
disability. Also, the individuals’ personal financial resources will often be limited in
sustainability.

Page 6

The penultimate paragraph of Core Reading has been amended to read:

Policyholders may also need a regular income on incapacity to cover premiums they are
paying for other types of insurance policy (eg endowment assurance or insured pension
arrangements). However, because the premiums for such insurance policies are likely to be
small, it would be unusual to take out income protection cover solely for this purpose
(except possibly to cover substantial pension premium contributions).

Page 8

The following sentence has been added before the bullet list:

Tiered benefits for CI Insurance policies may enable the CI Insurance policy to meet the
policyholder needs better. It:

Chapter 7
Page 15

The following sentence has been added to Section 3.1 (between the first two paragraphs of ActEd
text):

Offering tiered benefits for a CI insurance policy could create difficulties for the insurance
company.

Page 19

The example in brackets (usually a hospital plus surgeon plus anaesthetist) has been deleted
from the second paragraph of Core Reading.

Page 20

In the second bullet point, the final word has been changed from eradicated to removed.

Chapter 8
Page 21

In the fourth paragraph of Core Reading, the word conduit has been changed to channel.

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SP1: CMP Upgrade 2019/20 Page 5

Chapter 14
Page 11

The sentence in Section 3.1 has been amended to read:

A large database will be needed to be able to calculate rates that are age, gender and
duration dependent, and also allow for the influences of occupation and cause of claim.

Page 13

The second paragraph of Core Reading has been amended to read:

The actuary will need separate rates of mortality, for healthy (non-claiming) lives for IP
insurance, LTCI and CI insurance, and for lives in claim for IP insurance and LTCI.

Chapter 15
Page 20

The following sentence has been amended to read:

The investment return assumption will grow in significance as the likely benefit date is
further into the future (eg pre-funded long-term care insurance) or where guarantees are
given (eg on accelerated critical illness cover).

Page 21

The following sentence has been amended to read:

Note for PMI, the investment return assumption is expected to have minimal impact.

Chapter 17
Page 18

The following sentence has been deleted:

The examination requires an awareness of the relevance of each point to the product being
modelled – but students are not expected to expand on these in detail.

Chapter 21
Page 15

The final paragraph of Core Reading has been amended to read:

These assets may be valued at market value or may be discounted in certain circumstances,
for example if they are required to be retained within the fund to cover solvency capital
requirements.

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Page 6 SP1: CMP Upgrade 2019/20

Page 16

The penultimate paragraph of Core Reading has been amended to read:

For without profits business, the present value of future profits is effectively the release of
any margins within the supervisory reserves relative to the assumptions used within the
embedded value calculation. It is important that the reserves used in the determination of
net assets are consistent with those used in the determination of the present value of future
profits.

The following sentence of ActEd text has also been deleted:

Here, embedded value is just referring to the present value of future shareholder profits (PVFP) on
existing business.

Chapter 24
Page 4

The first sentence of Core Reading has been amended to read:

Health and care events are often less easy to predict than their life insurance counterparts
and greater care has to be taken in the wording of options and guarantees, the prices
charged for them and the reserves held to provide for their utilisation also require careful
consideration.

Page 8

In the second paragraph of Section 4.3, the words medical expenses covers have been replaced
by private medical insurance.

Chapter 26
Page 10

The first sentence of the second paragraph of Core Reading has been amended to read:

Generally health and care insurance tends to be reinsured on a treaty, rather than a
facultative, basis.

Page 30

In the final paragraph of Core Reading, the words or attachment point and or exhaustion point
have been deleted.

© IFE: 2020 Examinations The Actuarial Education Company

SP1: CMP Upgrade 2019/20 Page 7

Chapter 27
Page 12

In the third paragraph of Core Reading, the second sentence has been amended to read:

The insurer's decision will depend on the materiality of the discrepancy and whether there
have been attempts to act fraudulently or withhold information.

Chapter 28
Page 12

The fourth bullet point has been amended to read:

a requirement to hold a certain proportion of total assets in a particular class – for

example government stock

Chapter 29
Page 23

In the first sentence of Core Reading, the word straddle has been changed to include.

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 Page 8 SP1: CMP Upgrade 2019/20

2 Changes to the X Assignments

Overall
There have been minor changes throughout the assignments, including the wordings of questions
and mark allocations.

Where the changes in wordings have not affected what the question is actually asking, these
details are not included below. Changes to mark allocations and any other (more significant)
changes are listed below.

Assignment X1
Solution 1.1

Part (d):

The first point has been amended to read:

The word total in the definition usually means the failure of ability to perform a major or
substantial part of the job or function. [½]

Question and Solution 1.2

The parts (a) and (b) with a combined [5] allocation has been replaced by:

(i) pre-authorisation [2]

(ii) preferred provider agreements. [3]

[Total 5]

Solution 1.4

Part (ii):

The following points, formerly worth quarter marks, are now worth half marks:

An indemnity-based product would automatically provide inflation proofing. [½]

Cash-based benefits may also be index-linked. [½]

Solution 1.5

The quarter marks for the tabulated figures have been replaced by the following mark allocation:

[2 for 6 correct figures, subtract ½ for each error]

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SP1: CMP Upgrade 2019/20 Page 9

Solution 1.8

Part (i)(a):

The following point, formerly worth a quarter mark, is now worth half a mark:

The class in which a particular occupation falls into may vary by insurer. [½]

Part (i)(b):

The first bullet list has had the mark allocation amended as follows:

[½ for each two examples, maximum 1]

Part (ii):

The following point, formerly worth a quarter mark, is now worth half a mark:

Alternatively, premiums may be reviewable at intervals, eg every five years. [½]

The second bullet list has had the mark allocation amended as follows:

[½ for two examples]

Question 1.10

The bullet points have been replaced by parts (i) to (v) (with separate mark allocations) as follows:

(i) the benefits that might be provided [5]

(ii) the policy conditions for claiming [2]

(iii) the underwriting procedures that might be used [3]

(iv) the premium rating structure [4]

(v) the use of incentives to encourage the renewal of policies. [2]

Solution 1.10

Part (iv):

The bullet list has had the mark allocation amended as follows:

[½ for each two factors]

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Page 10 SP1: CMP Upgrade 2019/20

Assignment X2
Solution 2.7

Part (iii):

The following sub-bullet points, formerly worth quarter marks, are now worth half marks:

– incapacitated enough so that they are unable to perform their own occupation,
but still able to perform a suited occupation [½]
– severely incapacitated [½]

Solution 2.8

Part (i):

The first bullet list has had the mark allocation amended as follows:

[½ for each two variables, maximum 2]

Solution 2.9

Part (ii):

The following points in the ‘competition’ section, formerly worth quarter marks, are now worth
half marks:

... the design of these products (eg benefit levels, claims definitions) ... [½]

... and how successful they have been. [½]

© IFE: 2020 Examinations The Actuarial Education Company

SP1: CMP Upgrade 2019/20 Page 11

Assignment X3
Solution 3.3

The following points in the ‘expense assumptions’ section, formerly worth quarter marks, are now
worth half marks:

Such an expense investigation would involve assigning expenses:

by policy type [½]
as initial / renewal / termination expenses [½]
as fixed or variable expenses. [½]

Solution 3.4

Part (ii):

The marking of the formula has been amended to remove the quarter marks as follows:

Under certain conditions the CAPM gives:

Ei r Em r i [½]

where: Ei E ri is the expected return on asset i (eg the company’s shares, as it is a

proprietary company)
r is the market return on a risk-free asset

Em E rm is the expected market return (eg the stock market)

i is the ‘beta factor’ of asset i (defined as the covariance of ri and rm divided by

the variance of rm) – a measure of the relative volatility of asset i.
[½ for two terms defined correctly, 1 for all four terms defined correctly]

Solution 3.5

Part (i)(a):

The bullet list has had its mark allocation amended as follows:

[½ for each two factors, maximum ½]

Solution 3.6

Part (i):

The fourth bullet point has had the mark allocation amended as follows:

[½ for each two types of market data, maximum 1]

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Page 12 SP1: CMP Upgrade 2019/20

Part (ii):

The second bullet point has had the mark allocation amended as follows:

[½ for two sensible suggestions]

Part (iv):

The first point in the ‘disadvantages’ section has had its quarter mark allocation removed, so it
now reads:

Claim costs may actually be higher:

if treatments are more cost effective in other countries [½]
as there will be greater demand for hospital treatments in XYZ. [½]

Solution 3.7

Part (i)(a):

The second bullet point has had the mark allocation amended as follows:

Allowance should also be made for:

default risk [½]
tax / investment expenses. [½]

Part (i)(c):

The second point (and following bullets) has had the mark allocation amended as follows:

The insurance company will be prudent to assume high inception rates and/or low recovery rates
(ie long durations of sickness). [½]

Part (i)(d):

The first bullet list has had the mark allocation amended as follows:

[½ each, maximum 1]

Part (ii):

The following bullet points, formerly worth quarter marks, are now worth half marks:

In addition, the pricing basis will require the following assumptions, which are not needed for
reserving:
initial expenses (only future expenses are included in the reserving basis) [½]
profit criterion. [½]

© IFE: 2020 Examinations The Actuarial Education Company

SP1: CMP Upgrade 2019/20 Page 13

Assignment X4
Solution 4.1

Part (ii):

The bullet lists have had their mark allocation amended as follows:

Under the multi-state modelling approach, policyholders are separately tracked through the
various stages of ‘healthy’ and ‘claiming’: [½]
healthy premium payers
lives falling sick within deferred period
lives becoming claimants following deferred period
lives recovering, reverting to premium payers
lives dying.
[½ for each two stages, maximum 1]

Each subclass will have its own set of transition probabilities: [½]
sickness inception
lapse
mortality
recovery
policy expiry.
[½ for each two probabilities, maximum 1]

Solution 4.2

Part (iii):

The following points under the ‘claims’ section have had their mark allocation amended to be:

It would therefore be better to use claims incurred instead of claims paid. [½]

This is the ultimate cost of claims that occur during the year, which includes:
claims paid during the year [½]
changes in the estimates of all claims reported but not settled [½]
changes in the estimates of claims incurred but not reported (IBNR). [½]

The estimates should allow for:

any terminations that have happened but have not been reported
claim payment delays.
[½ for any sensible suggestion]

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Page 14 SP1: CMP Upgrade 2019/20

Solution 4.4

Part (i):

The bullet list has had its mark allocation amended as follows:

[½ for each two factors, maximum 3]

Solution 4.5

Part (i):

The bullet list has had the mark allocation amended as follows:

[½ for two points]

Solution 4.7

Part (i):

The bullet list has had the mark allocation amended as follows:

[½ for each two assumptions, maximum 1]

Part (ii):

The following bullet points, formerly worth quarter marks, are now worth half marks:

Assumptions, in addition to those stated in part (i):

the same premium basis is used in one year’s time [½]
the benefit level is unchanged (at £50,000). [½]

Part (iii):

The bullet list has had the mark allocation amended as follows:

[½ for two valid assumptions]

The final mark allocation for this part has been amended to read:

[Maximum 3]

Part (iv):

The second bullet list has had the mark allocation amended as follows:

The estimate in part (iii), attempts to be more realistic, but this depends on the accuracy of the
explicit assumptions made, in particular: [½]
the proportion of lives exercising the option [½]
the mortality/morbidity of the option-takers in year 2. [½]

© IFE: 2020 Examinations The Actuarial Education Company

SP1: CMP Upgrade 2019/20 Page 15

Solution 4.8

Part (i):

The second point has been amended read:

For a low level of premium, the policyholder and family are entitled to a range of specific payouts
dependent on certain healthcare-related events. [½]

The bullet list has had the mark allocation amended as follows:

[½ for each two items]

Part (ii):

The bullet list has had the mark allocation amended as follows:

[½ for each two items, maximum 1]

Assignment X5
Solution 5.5

Part (ii):

The first bullet list has had its mark allocation amended as follows:

[½ for each two factors, maximum 1½]

The second bullet list has had its mark allocation amended as follows:

[½ for each two factors, maximum 1]

Solution 5.8

There have been a number of minor changes throughout this solution. Replacement pages are
also attached.

Solution 5.9

The first bullet list in the ‘new business volumes’ section, has had its mark allocation amended as
follows:

[½ for two reasons]

The bullet list in the ‘overall’ section, has had its mark allocation amended as follows:

[½ for each two items, maximum 2]

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Page 16 SP1: CMP Upgrade 2019/20

Assignment X6
Solution 6.2

The first bullet list has had its mark allocation amended as follows:

[½ for each two suggestions, maximum 2]

Solution 6.4

Part (i):

The third, fourth and fifth points have been combined and had their mark allocations amended as
follows:

The next stage would be to consider to what extent the strategy can diverge from this best
matching portfolio of assets in order to achieve higher expected returns for shareholders, ... [½]

... while maintaining a level of risk that is in line with the company’s capital resources. [½]

In the first bullet list, the second bullet point and following point have been combined and had
their mark allocations amended as follows:

expenses should also be incorporated, possibly using an inflation model. [½]

The following two points have also been combined and had their mark allocations amended as
follows:

Correlations should be allowed for, eg index-linked liabilities will be linked to investment

conditions. [½]

The second bullet list has had its mark allocation amended as follows:

[½ for each two items, maximum 1]

In the final bullet list, the sub-bullets have been combined into the following bullet point:

the effect of the investment strategy on product development and pricing and/or the
views of ratings agencies [½]

Solution 6.5

Part (ii):

The first bullet list has had its mark allocation amended as follows:

[½ for each two items / points / examples]

The second bullet list has had its mark allocation amended as follows:

[½ for each two items / points / examples]

© IFE: 2020 Examinations The Actuarial Education Company

SP1: CMP Upgrade 2019/20 Page 17

Part (iii):

The first bullet list has had its mark allocation amended as follows:

[½ for each two components]

The third bullet list has had its mark allocation amended as follows:

[½ for each two suggestions]

Solution 6.7

Part (i):

The first bullet list has had its mark allocation amended as follows:

[½ for each two types of expenses]

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 Page 18 SP1: CMP Upgrade 2019/20

3 Other tuition services

In addition to the CMP you might find the following services helpful with your study.

3.1 Study material

We also offer the following study material in Subject SP1:

Flashcards
Revision Notes
ASET (ActEd Solutions with Exam Technique) and Mini-ASET
Mock Exam and AMP (Additional Mock Pack).

For further details on ActEd’s study materials, please refer to the 2020 Student Brochure, which is
available from the ActEd website at www.ActEd.co.uk.

3.2 Tutorials

We offer the following (face-to-face) tutorials in Subject SP1:

a set of Regular Tutorials (lasting three full days)
a Block (or Split 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.

3.3 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 2020 Student Brochure, which
is available from the ActEd website at www.ActEd.co.uk.

3.4 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 SP1@bpp.com.

© IFE: 2020 Examinations The Actuarial Education Company

SP1: Assignment X5 Solutions Page 13

Solution X5.8

This question is taken from Subject ST1, September 2005, Question 9.

Methods of reducing the premium will require wide thinking from a range of chapters. It is
important to know the main components that make up a premium, as well as the other factors
that might affect premium rates: Chapter 19, Pricing (3), Other considerations, may be useful here.
The material on product design in Chapter 7 will probably be the main source of ideas, however
Chapter 8 (Distribution channels), Chapter 26 (Reinsurance) and Chapter 27 (Other risk
management techniques) may help too.

Many of the risks associated with each method should be common sense. The nature of risks is
covered in Chapters 23, 24 and 25.

General risks

Reducing premiums lead to lower profits, unless there are offsetting actions. [½]

Some of the changes made may not be in line with customer needs or expectations, and so they
may be unpopular (with customers, employees or sellers). [1]

This may result in:

• dissatisfied customers [½]
• reduced sales volumes [½]
• higher lapses. [½]

Other changes may lead to increased expenses, eg administration and IT costs. [½]

Specific methods and associated risks

The insurer could reduce or restrict benefits, ... [½]

... eg limit maximum benefit amount, ... [½]

... limit benefit escalation rates, ... [½]

... increase deferred periods, ... [½]

... or offer long-term claimants with high reserves a lump sum instead of regular benefit
payments. [½]

Alternatively, the insurer could offer a more restricted term, ... [½]

... eg lower termination age(s) or a fixed term. [¼]

The insurer could change the claim definition, ... [½]

... eg from own occupation any occupation. [½]

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Page 14 SP1: Assignment X5 Solutions

The insurer could introduce benefit features designed to reduce overall claims costs, … [½]

... eg a linked-claim period, ... [½]

... or a rehabilitation service to help claimants back to work (possibly combined with a
requirement to notify claims early). [½]

The risk here is that the expected reduction in claims cost does not materialise, eg the claimant
might not be aware of these benefits. [½]

The insurer could remove or reduce options, ... [½]

... eg GIOs. [¼]

The risk here is that policyholders that would otherwise exercise an option are not able to, and so
they take out a policy elsewhere. [½]

The insurer could reduce the extent of guarantees, ... [½]

... eg extend the use of reviewable terms ... [½]

... or offer unit-linked policies. [½]

The risks here are that:

• customers may not understand reviewable terms and so their expectations would not met
if premiums are subsequently increased [½]
• selective withdrawals increase. [½]

The insurer could design the product to have low initial premiums that increase in a pre-specified
way. [½]

The risks here are that:

• the low premium level is only temporary and so subsequent increases are unpopular [½]
• there are higher future lapse rates. [½]

The insurer could allow for the policyholder’s previous claims experience in its pricing (eg NCD).
[½]

The risks here are that:

• the complexity of the product may put some people off [½]
• a discount based on sickness experience may be seen as unfair or unpopular [½]
• the premium increase after a claim may result in high levels of lapse [½]
• the discounts offered might be incorrect (eg because they were based upon poor or
scanty data). [½]

© IFE: 2020 Examinations The Actuarial Education Company

SP1: Assignment X5 Solutions Page 15

The insurer could try to target customers with characteristics that have better claims experience,
... [½]

... eg by changing rating factors (such as age and gender if permitted by legislation). [½]

The risks here are that:

• the increased sales process might deter potential customers and sellers [½]
• premium levels will increase for some customers. [½]

The insurer could try to reduce expense levels, ... [½]

... eg streamline processes, ... [¼]

... or pay less commission. [½]

The risks here are that:

• reduced marketing costs or commissions could result in reduced sales volumes [½]
• increased commission clawback levels would have a similar effect and incur additional
administration expense [½]
• reduced underwriting or claims control measures could lead to higher levels of claims [½]
• reduced customer service costs could lead to lower levels of customer satisfaction,
leading to higher lapses. [½]

The insurer could use more cost-effective distribution channels, eg the internet. [½]

The risk here is that the assumptions used to establish that the new channel is more cost effective
might not be borne out. [½]

The insurer could adjust the extent of cross-subsidies in expense loadings, ... [½]

... eg large policies subsidise small ones to make small ones cheaper. [½]

This could lead to a different mix of business from expected. [½]

The insurer could use reinsurance more effectively, ... [½]

... eg make use of tax / solvency arbitrage, ... [½]

... or use less reinsurance. [½]

This might lead to the insurer:

• being subject to more risk, eg claim volatility [½]
• needing more capital due to the increased risk. [½]

Also, any tax / solvency arbitrage opportunities may only be short lived and may be removed in
the future. [½]

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Page 16 SP1: Assignment X5 Solutions

The insurer could use more stringent underwriting, ... [½]

... eg increasing the use of exclusions, ... [½]

... or the number of declined applications. [½]

The risks here are that the:

• cost of employing more underwriting staff may outweighs any savings [¼]
• process involved may deter many (healthy) potential customers. [½]

The insurer could increase claim control and claim management. [½]

The risks here are that:

• additional cost outweighs any savings [¼]
• if a third party is used, it may not do its job properly or bring the insurer into disrepute [½]
• there may be an increase in the number of claim disputes or unhappy claimants. [½]

It could improve investment performance to obtain a higher return on assets. [½]

This could result in greater risks of volatile capital values or default, ... [½]

... or increased capital requirements. [½]

It may be constrained by regulation. [½]

The insurer could try to improve persistency, ... [½]

... eg through improved customer service. [½]

The risk here is that cost of such measures may outweigh the benefits. [¼]

The insurer could reduce the profit criterion.. [½]

The risks here are that:

• increased volumes may not be as expected (eg due to competitors cutting rates) [½]
• losses, or even insolvency, are more likely [½]
• premiums need to be increased later, which may be very unpopular. [½]

The insurer could weaken other assumptions in the pricing basis. [½]

This could lead to a greater risk of assumptions turning out to be worse than expected, leading to
reduced profits for the office. [½]
[Maximum 21]

© IFE: 2020 Examinations The Actuarial Education Company

SP1: CMP Upgrade 2020/21 Page 1

CMP Upgrade 2020/21

Subject SP1

CMP Upgrade
This CMP Upgrade lists the changes to the Syllabus objectives, Core Reading and the ActEd
material since last year that might realistically affect your chance of success in the exam. It is
produced so that you can manually amend your 2020 CMP to make it suitable for study for the
2021 exams. It includes replacement pages and additional pages where appropriate.
Alternatively, you can buy a full set of up-to-date Course Notes / CMP at a significantly reduced
price if you have previously bought the full-price Course Notes / CMP in this subject. Please see
our 2021 Student Brochure for more details.

This CMP Upgrade contains:

all significant changes to the Syllabus objectives and Core Reading.
additional changes to the ActEd Course Notes and Assignments that will make them
suitable for study for the 2021 exams.

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 Page 2 SP1: CMP Upgrade 2020/21

0 Retaker discounts
When ordering retaker-price material, please tick the relevant box when using the e-store or use
the designated place on the order form.

Students have the choice of purchasing the full CMP (printed or eBook) or just the Course Notes
(printed). You may need to add dispatch charges to the prices below.

Retaker price
2021 printed CMP for those having previously purchased the full- £65
price Subject SP1 CMP
2021 printed Course Notes for those having previously purchased £49
the full-price Subject SP1 Course Notes or CMP

2021 CMP eBook for those having previously purchased the full- £23 (+VAT in EU)
price Subject SP1 CMP

2021 Course Notes eBook for those having previously purchased the £23 (+VAT in EU)
full-price Subject SP1 Course Notes or CMP

© IFE: 2021 Examinations The Actuarial Education Company

 SP1: CMP Upgrade 2020/21 Page 3

1 Changes to the Syllabus objectives

There were no significant changes to the Syllabus objectives.

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 Page 4 SP1: CMP Upgrade 2020/21

2 Changes to the Core Reading and ActEd material

This section contains all the non-trivial changes to the Core Reading and ActEd material.

Chapter 1
Page 14

The final sentence of Core Reading on this page has been deleted.

Page 15

The first sentence of Core Reading on this page has been amended to read:
Some policies that are written to an expiry age have premiums that are payable for an exact
number of years.

Page 21

In the first paragraph of Core Reading on this page, the final sentence has been amended to read:

An insurer that bowed to pressure, did not increase rates on business, and expected to
have poor experience would have to be careful that it did not create a policyholders’
expectation that there would never be such increases.

In the second paragraph of Core Reading on this page, the first sentence has been amended to
read:

Reviews of premiums can result in ‘selective lapsing’.

Chapter 3
Page 11

In Section 3.2, the first paragraph of Core Reading has been amended to:

The type of benefit could be selected from a range of alternatives, including a single lump
sum payment, an annuity certain, a lifetime benefit subject to ongoing disability, a restricted
benefit (eg payable for a maximum period, or to a maximum total amount) subject to
ongoing disability, or possibly full indemnity.

Page 12

The first bullet point under the ‘Benefit options’ subheading has been amended to read:

length of deferred period

© IFE: 2021 Examinations The Actuarial Education Company

SP1: CMP Upgrade 2020/21 Page 5

Chapter 6
Page 16

There have been a number of changes to both the Core Reading and ActEd text in the ‘Cash vs
indemnity’ section. A replacement page is attached.

Page 18

In Section 4.2, the first paragraph of Core Reading has been amended to read:

The individual with dependants (spouse and/or children) needs the comfort of knowing that
there will be an income stream in the future. In order for the individual to provide for their
upkeep and welfare, if they are unable to work, or must take a lower-paid job, due to ill
health.

Chapter 7
Page 11

The first sentence of Core Reading on this page has been deleted.

Chapter 8
Page 9

The first sentence of Core Reading on this page has been amended to read:
Indemnity commission may be paid to any distributor who needs cash ‘up-front’ to develop
their businesses, eg to support the cost of marketing ahead of commission from resulting sales.

Chapter 10
Page 4

In the third paragraph of Core Reading, the first sentence has been amended to read:
The role that the State itself plays in fostering a healthy nation depends on the style and
culture of politics within the country.

Page 7

In Section 1.5, the second paragraph of Core Reading has been amended to read:
State healthcare programmes may be part of national culture and so radical changes may
be difficult to introduce, especially in the short term, because of the difficulties in getting
political agreement for these changes.

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Page 6 SP1: CMP Upgrade 2020/21

Chapter 12
Page 3

The third paragraph of Core Reading on this page has been amended to read:
The cost of obtaining and analysing the data, and suitability of the format of the data, may
be other criteria to consider.

Page 8

In Section 3.1, the Core Reading before the bullet point list has been amended to read:
However, use of population data has drawbacks:

Chapter 17
Page 4

In Section 1.2, the second point in the bullet point list has been amended to read:
lives that have fallen sick, but are still within the deferred period

Page 7

The first question and solution on this page has been amended to read:

Question

Explain how over estimating the proportion of deaths from a critical illness ( kx ) could cause
problems for the accelerated CI contract.

Solution

Recall the formula for the incidence rate at age x for this contract:

ix 1 kx qx

Over estimating the proportion of deaths due to a critical illness would understate the cost of
claims and could lead to inadequate premiums or reserves.

Page 31

In the summary, in the ‘Income protection insurance’ section, the second bullet point has been
amended to read:
lives that have fallen sick, but are still within the deferred period

© IFE: 2021 Examinations The Actuarial Education Company

SP1: CMP Upgrade 2020/21 Page 7

Chapter 24
Page 10

In Section 5.5, the final sentence of the first paragraph of Core Reading has been amended to
read:
Examples of this in health and care insurance might arise where a small sickness insurer is
at risk of an outbreak of local illness, or where an insurer has concentrated on providing
group income protection to an industry that is now associated with a particular disease.

Chapter 25
Page 4

In Section 2, in the first point in the numbered list about ‘Policy data’, the Core Reading has been
amended to read:
1. Policy data: Are the policy records provided by the company complete and
accurate?

Chapter 26
Page 14

In the first paragraph of Core Reading on this page, the final sentence has been amended to read:
This proportion may be constant for all risks covered (quota share) or will relate the
insurer’s preferred monetary retention to the overall size of sum insured (surplus, under
long-term covers).

Chapter 29
Page 25

The Core Reading under the investment costs sub-heading has been amended to read:
These costs (including the investment department, purchase taxes, commission etc) would
be directly allocated to investment expenses and hence allowed for in assessing the
investment return to use for pricing etc.

Chapter 31
Coinsurance

The final paragraph of the coinsurance definition has been amended to read:
In other contexts, coinsurance also refers to the situation where two insurers share the risk
on a policy in agreed percentages and also may refer to reinsurance on an original terms
basis.

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Page 8 SP1: CMP Upgrade 2020/21

Rehabilitation / partial benefit

The first paragraph of the rehabilitation / partial benefit definition has been amended to read:
This IP benefit is payable when a claimant is transitioning from being completely unable to
work to complete recovery, and the claimant is able to return to work in a reduced capacity.
While the claimant is partially back at work the claimant’s benefit may continue at a reduced
rate – this is a partial benefit. The amount of benefit is usually calculated in the same way
as that for proportionate benefit, as described above.

Treating customers fairly (TCF) (SA1)

The final paragraph of the treating customers fairly definition has been amended to read:
In some jurisdictions, this concept is well established, and can be written into local law. For
example in the UK the regulatory concept of Treating Customers Fairly (‘TCF’) is included
within UK regulations such that a firm must pay due regard to the interests of its customers
and treat them fairly.

© IFE: 2021 Examinations The Actuarial Education Company

 SP1: CMP Upgrade 2020/21 Page 9

3 Changes to the X Assignments

Throughout the assignments the solutions have been updated to remove references to gender.
For example, ‘he’ and ‘she’ has become ‘they’.

Assignment X2
Question 2.2

This question has been amended to read:

A non-executive director to a long-term insurance company has proposed that the company
should offer income protection insurance with a one-day deferred period. The director suggests
that this would have a substantial impact on the level of new business.

Discuss the potential problems with this strategy. [5]

Assignment X3
Question 3.5

The marks for part (i) of this question have been distributed between the sub-parts as follows:

(a) the demographic assumptions [4]

(b) the investment assumptions [3]
(c) the expense assumptions. [4]

This change has also been reflected in the solutions to this question.

Assignment X4
Solution 4.1

In the solution to part (ii), the second bullet point has been amended to read:

lives that have fallen sick, but are still within the deferred period

Solution 4.3

Under the sub-heading ‘Probability that the option will be exercised and the additional benefit
level that will be chosen’, the second point has been amended to read:

A policyholder who perceives themself to be in poor health or more susceptible to illness is more
likely to exercise the option, thus selecting against the insurer. [½]

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Page 10 SP1: CMP Upgrade 2020/21

Assignment X5
Question 5.8

This question has been slightly re-worded to read:

A well-established long term insurance office has been writing income protection business for
some years. The sales director, who has recently joined the organisation from another industry,
has sent an email to the pricing actuary expressing concern at the cost of income protection.

Describe typical means of reducing the premium for income protection insurance, describing the
risks associated with each. [21]

Solution 5.8

All points worth ¼ mark in this solution has been amended to score ½ mark, except the example
about GIOs on page 14 which has been incorporated into the previous point (which is still worth
½ mark).

Solution 5.9

The bullet point list under the ‘New business volumes’ sub-heading has been changed to score
½ mark for each example, with a maximum of 1 mark.

The bullet point list in the ‘Overall’ section has been amended to score ½ mark for each two
examples, with a maximum of 2 marks.

Assignment X6
Question 6.4

The first sentence of the question has been amended to read:

A proprietary health and care insurance company writes individual long-term care business.

© IFE: 2021 Examinations The Actuarial Education Company

 SP1: CMP Upgrade 2020/21 Page 11

4 Other tuition services

In addition to the CMP you might find the following services helpful with your study.

4.1 Study material

We also offer the following study material in Subject SP1:

Flashcards
Revision Notes
ASET (ActEd Solutions with Exam Technique) and Mini-ASET
Mock Exam and AMP (Additional Mock Pack).

For further details on ActEd’s study materials, please refer to the 2021 Student Brochure, which is
available from the ActEd website at www.ActEd.co.uk.

4.2 Tutorials

We offer the following (face-to-face) tutorials in Subject SP1:

a set of Regular Tutorials (lasting three full days)
a Block (or Split Block) Tutorial (lasting three full days)
an Online Classroom.

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.

4.3 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 2021 Student Brochure, which
is available from the ActEd website at www.ActEd.co.uk.

The Actuarial Education Company © IFE: 2021 Examinations

 Page 12 SP1: CMP Upgrade 2020/21

4.4 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 SP1@bpp.com.

© IFE: 2021 Examinations The Actuarial Education Company

 SP1-06: Product design and stakeholder interests (1) Page 15

3.4 Long-term care insurance

Cash vs indemnity
LTCI may provide cash or indemnity benefits.

The main need of the individual in this case may be an indemnity benefit that would cover
the cost of care in the future, should the individual require it. However, few insurers (if any)
will fund for care, ie will promise to indemnify the policyholder’s residential and medical
costs from incapacity in the future for the balance of lifetime, since this is deemed to be too
uncertain a liability. The insurer will generally take a longevity (annuity) risk and may
additionally promise to increase benefit levels in line with a suitable objective index of costs
– but this is far short of indemnification.

The uncertainties mentioned above surround the probability of a claim, the duration of the claim
and the amount of the claim payment(s).

The probability of claims will depend on:

the types of accidents and illnesses that result in a need for care in the future
new methods of treatment (eg a cure for Alzheimer’s disease) and advances in care
technology (eg improved post-stroke care).

The duration of claims may also be affected by advances in medical treatment, for example, they
may prolong the policyholder’s life when they are receiving care.

The amount of claim payments will depend on:

the costs of care (eg salaries of care workers)
how care is provided (eg more high-tech care may be more expensive)
changes in the supply and demand for care services.

It is difficult (if not impossible) to forecast how these factors will change, therefore they may be
viewed as too uncertain to entertain by many insurers.

Lump sum vs income stream

Long-term care insurance generally provides a cash income, triggered by the onset of
incapacity. The benefit level is chosen at the time of purchase to meet estimated levels of
assistance at the time of need, in accordance with the policyholder’s means to pay
(estimated income).

This describes a pre-funded policy.

Alternatively, an immediate needs policy converts a lump sum into a lifetime income,
dependent on level of disability, at the time of need. Here also the level of benefit may
increase with worsening incapacity.

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3.5 Private medical insurance

Cash vs indemnity
Private medical insurance is normally an indemnity product – it pays the medical treatment
costs incurred by the policyholder and in many cases the insurer settles with the provider
of treatment directly. As described in Chapter 4, the insured event is treatment rather than
the diagnosis of an illness or condition.

Only under special circumstances will the plan provide cash, such as:

In territories where the State offers an alternative, the insurer may pay a daily benefit
in cash for time spent by the policyholder in a State hospital, which does not
otherwise incur cost for the insurer.
Such benefits are advertised to encourage individuals to reduce the insurer’s claim outgo,
by taking advantage of State-provided treatment where available.
Where there is a cap on the fees paid by the insurer for certain procedures, meaning
that the benefit is not full indemnity. The policyholder may need to cover the
difference if the hospital and/or consultant are charging more than the maximum.
It should be noted that some PMI products have excesses.
Other short-term products do provide cash benefits, in particular:

Health cash plans are special arrangements designed to provide cash when certain
medical events take place (eg physiotherapy, new spectacles).
Other examples of health-related events are a stay in hospital and the undergoing of
dental treatment.

The benefits under these plans are deliberately designed to provide a contribution to
policyholders’ medical costs, and not to provide full indemnification of these expenses; in
this way the risk of anti-selection is much diminished.
Major medical expense plans …
… which provide a lump sum when the policyholder undergoes surgery.
Personal accident plans, which provide a lump sum when the policyholder suffers a
specified injury.

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