CP1-0: What is Subject CP1 all about?

Page 1

What is Subject CP1 all

about?
Syllabus objectives
3.1 Describe the actuarial control cycle and explain the purpose of each of its
components.

3.2 Demonstrate how the actuarial control cycle can be applied in a variety of practical
commercial situations, including its use as a risk management control cycle.

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0 Introduction
When you first receive your Subject CP1 Course Notes, it is difficult to get over the sheer size of
them! However, it’s worth remembering that this subject is comparable in size to two
SP subjects, so it is going to be big. Once you have unpacked the material into binders and taken
a deep breath, we hope that you will feel ready for a gentle introduction to the subject.

It is important that you read this chapter since it does contain some (examinable) Core Reading.

In this chapter we will:

 give you an overview of the course structure
 introduce you to the important topic of the actuarial control cycle around which the
Subject CP1 course is based
 give an introduction to the important topic of risk
 explain how to study the course productively
 explain the structure of the exam and give advice on good exam technique
 cover a Core Reading example on the actuarial control cycle.

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1 Subject CP1 – the big picture

1.1 The rationale behind Subject CP1

Subject CP1, or Actuarial Practice, is a course about concepts. As a precursor to developing the
Core Reading, several practising actuaries were asked about the concepts that were of most
importance in their day-to-day work. They came up with ideas such as:
 the importance of understanding assets and liabilities and matching
 understanding and managing different types of risk
 balancing risk and return
 using different assumptions dependent upon the task and clients.

Many of these concepts span several actuarial disciplines, eg investment, general insurance, life
insurance and pensions. Therefore, rather than splitting the Subject CP1 course into disciplines,
the course is split into concepts. Within each concept, reference is made to how it relates
similarly to, or differently between, the various disciplines.

1.2 The framework of the actuarial control cycle

The Subject CP1 course is written around the actuarial control cycle (ACC). This is the first
important concept to get to grips with.

The ACC gives a framework for solving actuarial problems. The ACC looks like this:

The General Commercial

and Economic Environment

Specifying the Developing the

Problem Solution

Monitoring the
Experience

Professionalism

You may well be thinking that this is not a terribly exciting way to solve actuarial problems and
that the steps in the ACC are largely common sense. This is fair enough, but bear in mind that
when an actuarial task fails, it is often due to a breakdown in part of the ACC process.

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For example, you may have come across situations at work where the assumptions used in a
model are really outdated (ie the monitoring the experience stage of the ACC has broken down) or
where colleagues have failed to provide adequate documentation for a task (ie it could be viewed
that they have not been professional).

1.3 How does the ACC relate to Subject CP1?

The Core Reading for Subject CP1 is built around the actuarial control cycle. The diagram below
shows how the key topics from Subject CP1 fit into the ACC.

The General Commercial and Economic Environment

– Providers of benefits
– Regulation
– The external environment
– Insurance products
– Asset classes
– Economic influences
Specifying the Problem Developing the Solution
– Risk and risk management – Modelling
– Contract design – Data
– Capital requirements A – Setting assumptions
– Pricing and financing
C – Provisioning

C –
–
Asset management
Capital management
– Surplus management
– Accounting and reporting
Monitoring the Experience
– Monitoring
– Analysis of surplus
Professionalism
– Actuarial advice

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2 The actuarial control cycle

The actuarial control cycle is a model that can be applied to many aspects of actuarial work.
Like all models, it does not necessarily always fit the problem under consideration at all
times or in all circumstances. However, like all good models, it is simple, and it helps the
user to obtain a clearer understanding of the situation.

The actuarial control cycle is a fundamental tool of risk management – the process of
analysing, quantifying, mitigating and monitoring risks.

The central part of the model is based on a simple approach to problem solving:

 firstly, define the problem

 then design and implement a solution

 then monitor the effectiveness of the solution and revise it if necessary.

This involves the following processes:

 Analyse situations, products and projects to determine the risks to which they are
exposed.

 Quantify the financial consequences of the risk events occurring.

 Consider and quantify appropriate methods of managing, mitigating or transferring

the risks.

 Monitor the situation and the risk management procedures implemented as time
develops.

 In the light of experience modify or change the risk management approaches

adopted.

The final bullet point above indicates that the process is cyclical. The approach used in
almost all risk management tasks is that of the actuarial control cycle.

The actuarial control cycle can be represented diagrammatically, as:

Specifying the problem Developing the solution

Monitoring the experience

The actuarial control cycle must of course be considered in the context of the specific
economic and commercial environment in which it is being used. For example, in a
particular scenario it might be necessary to consider legislation, taxation, and economic
trends.

In addition the requirements of professionalism must be recognised at all stages of the

cycle.

2.1 What makes the actuarial control cycle a ‘control cycle’?

Actuarial work usually includes all phases of the cycle. The term ‘cycle’, and the use of
two-way arrows in the diagram, highlights the importance of monitoring and feedback, and
the inter-relationships between elements of the cycle.

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In actuarial and risk management work, the feedback mechanism within the cycle is not an
automatic process resulting in a pre-determined, unconscious adjustment, as happens in
some engineering systems. The feedback mechanism in the actuarial control cycle requires
the actuary to exercise professional judgement.

2.2 What makes the actuarial control cycle ‘actuarial’?

Although the underlying problem-solving model is completely general, the actuarial control
cycle incorporates the following basic elements, which are common to all actuarial and risk
management work:

 the estimation of the financial impact of uncertain future events

 a long-term rather than short-term horizon

 the recognition of stakeholders’ requirements and risk profiles

 decisions need to be made in the short term in the light of likely future outcomes

 the use of models to represent future financial outcomes

 the use of assumptions based on appropriate historical experience

 the need to allow for the general business environment – the impact of legislation,
regulation, taxation, competition

 interpretation of the results of modelling to enable practical strategies to be

developed

 monitoring and periodically analysing the emerging experience

 modifying models / strategies in the light of this analysis of the emerging experience

 the application of professional judgement.

2.3 The steps in the actuarial control cycle

The following sections discuss the individual components of the actuarial control cycle.

The general economic and commercial environment

This step of the process sets the scene and ensures the actuary is fully aware of the environment
in which the problem is being solved and the impact of the environment on the decisions made.

Clearly the context or environment will depend on the field in which the actuary is working.

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Example

An actuary working in the field of investment and asset management will want to be aware of the:
 terminology used in investment and asset management
 characteristics of the assets and the markets in which a fund might invest
 possible returns from both income and capital gain on major asset classes and the
variability of these returns
 correlation of returns between asset classes and correlation of the returns with changes
in the value of the investor’s liabilities
 legislative and regulatory framework for investment management and the securities
industry
 ways in which investment returns are taxed and how this affects investor behaviour
 assets invested in by competitors and any performance benchmarks
 impact of any relevant professional guidance.

Question

List the factors that would make up the general economic and commercial environment for an
actuary working in general insurance.

Solution

The general economic and commercial environment of an actuary working in general insurance
includes:
 customer needs and how those needs are changing over time
 different types of general insurance products, who uses these products and the
associated risks
 the competition, the products they offer and the prices they charge
 jargon used in the industry
 main features of the insurance market and the different marketing strategies
 reinsurance products and the terms on which they are available
 effect the economy has on an insurer’s operations
 rules and regulations
 impact of professional guidance.

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Specifying the problem

The first stage of the actuarial control cycle is to identify and analyse the risks of the
various stakeholders in detail, and to set out clearly the problem from the point of view of
each stakeholder.

This stage of the control cycle considers the strategic courses of action that could be used
to handle the particular risks in question. It gives an assessment of the risks faced and how
they can be managed, mitigated or transferred. This will reflect the desire of most
institutions to manage their risk both in their core business and in activities incidental to
their core business.

Question

A financial services provider is considering developing an investment product that will give access
to the stock market to customers who wish to save regular, small amounts of money. The
financial services provider will collect customers’ premiums and manage their investments on
their behalf (for an appropriate charge).

Describe the key risks to which this product gives rise for the provider.

Solution

Key risks to the financial services provider include:

 The risk of customer dissatisfaction – this is probably most likely to arise if the investment
return the provider achieves for its customers is poor, especially if it is worse than that of
its competitors.
 Expense risks – such as the risk that the charges the company receives from customers are
insufficient to cover the expenses that the provider incurs.
 The risk of poor sales – this will result in limited spreading of fixed costs such as the
development and launch costs of the new product (which will be incurred regardless of
the volumes sold). Also, there will be less spreading of overhead expenses.

This stage also provides an analysis of the options for the design of solutions to the
problem plans that transfer risk from one set of stakeholders to another.

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Developing the solution

This stage involves:

 an examination of the major actuarial models currently in use and how they may be
adjusted for the particular problem to be solved.

 selection of the most appropriate model to use for the problem, or construction of a
new model.

 consideration and selection of the assumptions to be used in the model. The

assumptions used in a model are critical and it is necessary for the actuary to have a
good understanding of their sensitivities.

 interpretation of the results of the modelling process.

 consideration of the implications of the model results on the overall problem.

 consideration of the implications of the results for all stakeholders.

 determining a proposed solution to the problem.

 consideration of alternative solutions and their effects on the problem.

 formalising a proposal.

 communicating the proposed solution, and alternatives, to the stakeholder(s)

responsible for decision taking.

The most important model is likely to be one consisting of the future cashflows expected on an
individual contract or benefit scheme or a portfolio of business.

Monitoring the experience

It is critical that the models used are dynamic and reflect current experience where that is
relevant. This stage deals with the monitoring of experience and its feedback into the
problem specification and solution development stages of the control cycle, such as
updating the investigation.

We can analyse individual elements of experience (claim rates, investment returns, mortality,
salary growth, expenses etc) in order to compare actual experience with what had been assumed.
The assumptions made will rarely turn out to be correct and may lead to a wrong solution
(eg unprofitable premium rates). With more up-to-date information the assumptions can be
revised and a new solution developed.

An important part of this monitoring will be the identification of the causes of any departure
from the targeted outcome from the model and a consideration as to whether such
departures are likely to recur.

Monitoring should be carried out regularly. For a new contract, where there is lots of uncertainty,
monitoring should take place more frequently initially.

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Feedback loops
It is vital that the results of the monitoring process are used. Monitoring might indicate that
the problem was not fully or correctly specified – in other words the solution developed
does not solve the problem that it now appears exists. Alternatively monitoring might
indicate that the solution as developed did not take some vital feature into account ...

... or some of the initial assumptions were incorrect.

More usually, the monitoring process indicates that the solution should be refined, perhaps
to bring it up to date, or to reflect current experience, rather than that the solution was not
appropriate. If these results are not fed back into the cycle it is likely that unsatisfactory
consequences for one or more stakeholders will result.

Professionalism
Professionalism needs to be demonstrated throughout the actuarial control cycle process and in
the communication of the results.

For example, relevant Technical Actuarial Standards should be followed and the views of all
stakeholders taken into account. We will consider professionalism in greater detail in the next
chapter.

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3 Practical applications of the actuarial control cycle

3.1 The overall picture

Each of the common actuarial issues set out below are representative of the practical
problems that arise in the areas in which actuaries work.

For example:

 identifying alternative investment and risk management options

 asset liability management

 determining the current level of profit or solvency and estimating future solvency

 assessing the need for capital to protect against the consequences of risk events

 assessing the need for and the calculation of provisions

 determining the contributions / premiums required to ensure that benefit promises

payable on future financial events can be met

 determining and monitoring mortality, expense and persistency assumptions for use
within the design of and reserving for contracts or schemes

 monitoring the effect of investment mismatching.

Solving these problems is likely to involve the use of techniques and concepts introduced
in the Core Principles subjects.

Discussing these problems and the issues that arise in addressing them forms the basis of much of
the remainder of Subject CP1 as well as later subjects. The actuarial control cycle provides a
framework for these discussions.

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4 Risk – the story so far

The topic of risk is a key theme for Subject CP1.

If you have previously studied financial economics you may well have been introduced to the
concepts of investment risk and credit risk. We will cover these and other examples of types of
risk in the course.

4.1 Investment risk

Most mathematical theories of investment risk interpret risk as being the uncertainty associated
with the outcome of making an investment. They might, for example, use variance of return as a
measure of investment risk.

4.2 Credit risk

Credit risk may be defined as the risk that a person or an organisation will fail to make a payment
that they have promised.

An example of credit risk for corporate bonds would be the failure to make interest payments on
set dates or failure to repay the face value of the bond on the redemption date.

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5 Risk – broadening your view

Subject CP1 builds on your prior knowledge of the concept of risk. As you work through the
course you will appreciate that, rather than attempting an in-depth analysis, it takes in a very
broad view. To this end, you need to step back from any earlier detailed studies of investment
and credit risk and establish a wider perspective.

At a fundamental level, risk might be considered to be exposure to actual events being different
from those expected (or desired!). However, this definition results in ambiguity.

Question

Suggest how an increase in real salary growth may be considered positively by one particular
individual or organisation and negatively by another.

Solution

Real salary growth being higher than expected might be seen by:
 employees as good news, especially if pension benefits are based on final salary!
 employers as bad news, assuming that it reduces profit margins and increases the cost of
running the business
 the Government as good news, in that income tax revenue will rise in real terms
 the Government as bad news, in that it may precipitate higher inflation.

In this sense, risk is a concept that is very much situation dependent (‘in the eye of the beholder’).
In Subject CP1 we consider a range of potential stakeholders, including, for example:
 investors
 lenders / creditors
 trustees
 members of benefit schemes (eg pension schemes)
 insurers
 beneficiaries of insurance policies
 reinsurers.

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Question

For each of the above potential stakeholders give examples of where the possibility of actual
events deviating from expected exposes them to risk. Try not to repeat yourself and come up
with different events for each stakeholder.

Solution

Investors – market prices don’t rise as fast as expected (or hoped for).

Lenders / creditors – customers to whom credit terms are given fail to pay what is owed.

Trustees – professional advice, which is relied upon in order to make decisions, proves to be
flawed.

Members with pensions in payment – retail prices rise faster than pension income.

Insurers – mortality rates assumed as part of the premium rating exercise turn out to be
optimistic due to poor vetting of applications, resulting in underwriting losses.

Beneficiaries – benefits under health insurance policies prove to be inadequate due to high levels
of medical cost inflation.

Reinsurers – risks ceded to a single reinsurer by multiple direct insurers were believed,
incorrectly, to be independent and a subsequent single event causes a catastrophic aggregate
loss.

For these and other stakeholders, risk generally occurs when:

1. the value of assets and/or asset proceeds (cashflows) are not as expected, or
2. the value of liabilities and/or liability outgoes (cashflows) are not as expected.

Asset proceeds might not be as expected due to:

 market risk – risks related to changes in investment market values
 credit risk – the risk of failure of third parties to repay debts.

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Liability outgoes might not be as expected due to many reasons:

 inflation risk – the risk of real liabilities being larger than had been anticipated due to
inflation, eg of salaries, consumer prices, medical costs, court awards.
 underwriting risk – the risk of failures in underwriting leading to the insurer taking on risks
at an inadequate price.
 insurance risk – the risk of more claims being made than expected (eg due to higher than
expected mortality or morbidity rates).
 exposure risk – the risk of more claims arising than expected from a particular event due
to the insurer having greater exposure to a particular peril (eg a tornado in Mexico) than
had been appreciated. This might be due to inadequate diversification within the
portfolio of business written.
 finance risk – the risk of not being able to obtain finance when required or not being able
to obtain it at the anticipated cost.
 operational risk – the risk of loss due to fraud or mismanagement within the organisation
itself.
 external risk – the risk arising from external events, eg changes in legislation.

The risks relating to asset proceeds and liability outgoes might present less of a problem if both
assets and liabilities ‘behave similarly’.

For example, in terms of cashflows, if liability outgoes correspond to asset proceeds, then actual
deviations from expected will present less of a risk than they might otherwise have done in
isolation.

Similarly, but thinking in terms of values, if assets are chosen whose values move in line with
those of the liabilities, then actual deviations from expected will present less of a risk than they
might otherwise have done in isolation.

Under such circumstances assets are said to be a ‘good match’ for the liabilities. (The full concept
of asset-liability matching is considered in detail later in this course.)

So we should modify the above list to state that risk generally occurs when:

1. asset values / proceeds are important in isolation to the stakeholder and they are not as
expected

2. liability values / outgoes are important in isolation to the stakeholder and they are not as
expected

3. asset values / proceeds and liability values / outgoes are not important in isolation to the
stakeholder, but the relative values (value of assets less value of liabilities) and/or net
cashflows (asset proceeds less liability outgoes) are important and are not as expected.

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Note that deviations of cashflows from expected might be in terms of:

 amount and/or
 timing.

Question

(i) Suggest an example from your own experience where a risk has arisen because of the
mismatch in the amount of asset and liability values and/or cashflows.

(ii) Suggest another example where the amounts of asset and liability cashflows are equal but
risk has arisen because of a mismatch in timing.

Solution

(i) I’ve saved regularly for three years to cover the cost of buying a replacement car. A risk
has arisen in that the accumulated savings may not be enough to cover the purchase price
due to car-price inflation exceeding that expected and/or interest rates on my savings
being less than expected.

(ii) My dental insurance covers the cost of having my teeth crowned but I have to pay for the
treatment first and then claim on the insurance afterwards. A risk has arisen because I
may need to borrow money to pay for such treatment resulting in an uncertain cost and
timing.

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6 Measuring risk
We started off our discussion of risk by reviewing what we had learned from prior studies of
financial economics. The emphasis in previous exams is on measuring risk – looking at the
variability of outcomes.

Now that we have an expanded view of risk it is perhaps helpful to have in mind a broader
quantification for measuring risk:

Risk = probability  impact

However, this quantification is also situation dependent in that the reaction of any one
stakeholder when faced with the same quantified risk will vary according to their:
 risk appetite
 objectives.

Question

(i) Outline why might different individuals have different appetites for risk.

(ii) Give examples of investors with differing objectives that make them perceive the same
risk in very different ways.

Solution

(i) Different appetites for risk

Appetite for risk may partly be a function of:

 age – older people may be more risk averse because they have less time to make up any
loss
 wealth – richer people may be more aggressive in their investment strategy and put a lower
value on insurance
 dependants – those with children to support may be more cautious in their investments and
place a high value on insurance.

(ii) Example of differences in perception

The risk of investing in a forest will be perceived very differently by an individual looking for a high
level of income compared to a charity that aims to combat global warming!

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7 Managing risk
All is not doom and gloom! When faced with risks we might take two, very positive, viewpoints:
1. ‘Risk is an opportunity!’
2. ‘We can manage risk successfully!’

Risk as opportunity
A price can be put on many risks faced by individuals and organisations. Anything that can be
priced offers the opportunity to make trading profits.

For example, insurance is all about the assessment and pricing of risk. If the price at which one
party is happy to accept a risk is less than the perceived cost of the risk to a second party, the
opportunity exists for a risk transfer to the mutual satisfaction of both parties. Such differences in
perception are likely to be linked to different risk appetites.

Mitigating risk
Having correctly identified the risks to which we might be exposed, the next step (using the
approach given by the actuarial control cycle) is to consider how they might be mitigated. For any
that can’t be avoided or eliminated – and for many that won’t be possible – careful management
and monitoring will be required.

One way of reducing risk is to avoid exposure to it! However, the mitigation of risk can take many
forms. For example, the table below shows three risks that may have a financial cost to an
individual and how these risks could be mitigated.

Risk Mitigation strategy

Death Life insurance policy.
Savings to tide me over the period before I expect to
Unemployment
be able to get a new job.
Illness Reliance on the State-provided health service.

Obviously these mitigation strategies are a matter of personal choice. Your own choices may be
very different!

Note that a mitigation strategy will change the level and/or nature of the risk but will rarely
eliminate risk. For example, the first and last strategies expose the individual to failure of third
parties. The second may or may not prove to be adequate, depending upon how long the
individual remains unemployed and the rate of increases in the cost of living.

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Mitigating risk might involve:

 avoiding
 accepting and minimising
 sharing or
 transferring
risk together with ongoing monitoring.

Question

Use each of the above mitigation strategies to suggest how each of the following risks can be
mitigated:
 the risk of poor investment performance to a life insurance company
 the risk of terrorist attacks on aeroplanes to an individual.

Solution

Avoiding:
 ceasing to write contracts with any investment guarantees
 not flying by air to avoid the risk of terrorist action

Minimising:
 designing a unit-linked insurance contract with investment guarantees that have an upper
limit
 only flying from airports that meet an internationally recognised security standard

Sharing:
 writing with-profit insurance contracts so as to share the investment risks with
policyholders
 pooling resources with other travellers and hiring executive jets as a group so as to have
more direct control over flight security

Transferring:
 using derivatives (eg options) to offset (or hedge) potential future losses from any
investment guarantees that are made or only offering unit-linked contracts under which
the policyholder accepts all of the investment risk
 delegating all tasks that require travel by air to others!

We’ll look at the risk management process and strategies for mitigating risks in more detail later
in the course.

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8 Getting the most out of your study sessions

The Subject CP1 study guide gives some good advice on studying and is worth reading. As a
summary, here are our top study tips:

1. As you read each chapter, condense the key ideas onto a single or double side of A4 – you
will retain a lot more by doing this recap and it will come in handy for revision, as you will
not need to trawl all the way through the course again. Alternatively you can annotate
the summary pages from each chapter.

2. Make your study as active as possible – this means having a go at all the questions (you
will learn very little by just looking at the solutions) and annotating the notes with your
own comments as you work through.

3. Attempt the assignments – the students who pass the exams tend to be the ones who are
practising a significant number of questions in advance of the exam and getting some
regular feedback from markers.

4. Make sure that you work through all the relevant past exam papers (prior to 2019, this
exam was called Subject CA1). Practising these questions will be useful as preparation for
both Paper 1 and Paper 2. You need to start looking at exam questions early on in your
studies – don’t leave this until the last couple of weeks!

5. Make sure that each study session contains a range of activities to keep up your interest,
including:
 reading new material
 recapping old material
 attempting questions.

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9 The Subject CP1 exam and good exam technique

9.1 The Subject CP1 exam

The Subject CP1 exam consists of two exam papers sat on different days. Each exam paper is
marked out of 100 and the scores of the two papers aggregated. There is no requirement to pass
or reach a minimum standard on each individual paper.

The X Assignments include both Paper 1 and Paper 2 style questions to help you prepare for the
exam.

Paper 1
The Paper 1 exam is 3 hours and 15 minutes long. The questions are expected to be between
5 and 15 marks in length. This paper will primarily test knowledge and straightforward
application skills.

Paper 2
The Paper 2 exam is 3 hours and 15 minutes long. At the time of writing this course it is expected
that this will consist of 45 minutes of planning time and 2 hour 30 minutes of writing time. During
the planning time candidates can make notes and plan their responses but not write in the
answer booklet.

Paper 2 is expected to consist of one or two case studies. The case study will provide background
detail relating to a scenario and there will be various questions to answer. This paper will test
more difficult application and higher order skills.

9.2 Doing well in the Subject CP1 exam

Subject CP1 may be the first wordy exam you have sat in a long time. Below are some exam
technique ideas that successful students have found useful in the past.

Bookwork vs applications
Some of the exam questions may be based purely on bookwork, requiring you to remember a set
of ideas from the course material. However, it is more likely that the questions will be
applications based with Core Reading underlying them.

Applications questions require you to take one or more concepts from the Core Reading and
apply them to a specific situation.

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Being general and specific

In applications questions, the examiners are looking for you to be both general and specific.
 The general comes from considering which bits of Core Reading are relevant to the
question.
 The specific comes from looking at the information given in the question and tailoring
your answer towards this. In particular for Paper 2 there is likely to be a large amount of
background information given to you and it will be important to understand this
information and use it well to illustrate your points.

Example

An exam question might say:

‘Explain why a multinational pharmaceutical company may require capital.’

The general points to mention will come from the Core Reading on why companies require
capital.

The specific points to mention come from the words multinational and pharmaceutical company
in the question. For example, because the company is multinational it will have operations in
different countries, you need to think about currency risks. Because it is a pharmaceutical
company you need to think about its day-to-day operations:
 research and development
 purchasing stock
 manufacturing drugs.

(Note that it’s quite normal not to be able to generate these thoughts if this is your first read
through of Chapter 0. They will hopefully come more naturally once you have finished the whole
course!)

When students go for exam counselling with the Institute and Faculty of Actuaries, they often find
that they are being either TOO GENERAL (and regurgitating Core Reading) or TOO SPECIFIC (and
forgetting the Core Reading altogether).

9.3 Idea generation

As you start to tackle past exam questions, you will realise that the examiners are looking for a
good breadth of ideas. Breadth of thinking rather than great depth on any one point is the key to
success in Subject CP1.

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It is so important to develop techniques for generating ideas. Some of the things that successful
students have found useful for idea generation include:

Acronyms

Study
Hard
And
Practice
Exam questions

(Whilst acronyms are useful for generating ideas, be careful not to abuse them. Be discerning
about which points are relevant to the actual question.)

Tables

Investment trust companies Unit trusts

Investor buys … Shares units
Purpose is … to gain access to a well-diversified portfolio of assets and
investment expertise
Share / unit priced at … discount / premium to net net asset value
asset value
… … …

Diagrams

Using the words in the question

Attractive
features

Profitability

Marketability
Level or
increasing?

Competition

Contract Lump sum

Benefit types
Design or series?
Factors
Regulation

Guaranteed or
Capital
discretionary?
efficiency

Discontinuance
benefits?

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As we saw in our previous example you can use the words in the question to help you generate
ideas, eg ‘multinational’, ‘pharmaceutical’.

We recommend that you start to draw up a grid of word associations, eg:

Word Association
multinational currency risk
research and development, stock,
pharmaceutical
manufacturing
lack of data, lack of capital, lack of
small company
diversification

It may sometimes seem like an impossible task to generate enough ideas for the exam. It is
something that gets easier once you start practising questions (and see that there are common
themes that come up time and time again).

9.4 How much should I write?

You need to generate many ideas on each question. As a rule of thumb (please note that this is
not an absolute statement), you can expect half a mark for each distinct idea made. Very
important, or complex ideas may get a full mark. It is important to get each point down succinctly
and then move on.

Adopting a bullet point style is great as long as you say just enough given the instruction word in
the question. This same concise style is appropriate in answering questions for both Paper 1 and
Paper 2.

Writing big, waffly paragraphs is not a good idea, as the distinction between your points will
become blurred – the harder your script is to mark, the less likely you are to get credit for ideas,
which you thought were distinct, but which the examiners cannot distinguish as they are buried in
a big long sentence (just like this one)!

If the question asks you to ‘List’ or ‘State’, then each point is almost certainly worth half a mark.
You just need to put the point down with no explanation.

For any of the other instruction words, such as ‘Describe’, ‘Discuss’, ‘Explain’ or ‘Outline’ you will
need to give a bit of detail, briefly explain why it is a relevant point or maybe give an example.
‘Discuss’ questions often require you to look at advantages and disadvantages.

Example 1
An exam question might say: ‘List the reasons for investing overseas.’

A good solution would be:

 match overseas liabilities
 diversification

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 increase expected returns.

Example 2
An exam question might say:

‘Explain the reasons for investing overseas.’

A good solution would be:

 Match overseas liabilities – choosing assets of the same currency as that in which the
liabilities are denominated hedges currency risk.
 Diversification – investing overseas gives access to different economies, stock markets,
industries and individual companies.
Investing in a number of different countries or economies with a low degree of correlation
helps to reduce portfolio risk.
 Increase expected returns – returns on overseas investments can be higher than domestic
returns because they are fair compensation for the higher risk involved.
 Alternatively, inefficiencies in the global market may allow fund managers to find
individual countries whose markets, or currencies are undervalued.

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10 Core Reading example

We will now look at a Core Reading example question on the actuarial control cycle.

Example
A life insurance company is about to enter the annuity market for the first time. It intends to
sell without-profit immediate annuities with higher annuities for those lives in ill health.

Describe how the actuarial control cycle can be used in the pricing and ongoing financial
management of the product. It is not necessary to discuss how the product might be
administered.

Although it will be difficult (especially on your first read through of the course), we recommend
that you have a go at answering this question, otherwise your study is likely to be passive and
ineffective. Some hints are given below.

Hints
It is helpful to start by highlighting the important features of the contract given in the question –
in this case a without-profit immediate annuity:
 The customer invests a lump sum.
 The life insurance company decides on the guaranteed amount of income to pay to the
customer, ie the annuity rate.
 The annuity payments start immediately and cease on the death of the customer.
 There are no benefits paid on other events, eg on surrender.

The best way to tackle actuarial control cycle questions is to consider each of the five stages of
the cycle in turn. Here are some things to think about at each stage:

Specifying the problem

 Set an objective – give an example that is specific to the question.

 Identify the risks / mitigation options – give examples specific to the question.

Developing the solution

 Often this involves building a model – suggest a type of model.

 Identify the assumptions for the model – give examples specific to the question.
 Suggest ways of dealing with any uncertainty in the assumptions.
 Talk about sensitivity testing – ie rerunning the model on different assumptions.

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Monitoring the experience

 Compare actual vs expected experience – give examples specific to the question.

 Analyse the differences in actual vs expected experience and suggest how you might deal
with them.
 Discuss how frequently the monitoring should occur.

Professionalism

 Think about the characteristics of a professional.

The general economic and commercial environment

 What external issues should be considered? Think about what you would like to know
about the competition.
 Why is the state of the economy potentially an issue?

Solution
Specifying the problem

The client will be transferring risk to the insurance company:

 Longevity risk will be transferred, as the annuity will be paid to the client regardless
of how long they live.

 Investment risk (including credit and market risk) will be transferred, as the client
will receive a guaranteed income, irrespective of market conditions.

The problem is to determine appropriate premium rates that:

 deliver an acceptable profit to the company

 are competitive in the market place otherwise little business will be written

bearing in mind that the company is new in the market and has little or no experience of the
product.

Developing the solution

The company will need a pricing (or profit testing) model that can project the future
development of this line of business in various circumstances. The model needs to be
developed or acquired, or an existing model modified.

The first stage in pricing the product is to determine the initial assumptions about future
experience.

The actuary will need to discuss the mortality basis with the underwriter to ensure that the
underwriting decisions are consistent with the pricing basis.

The actuary will need to discuss investment returns and the appropriate matching assets
with the investment managers ...

... bonds are likely to be the appropriate matching assets.

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Judgement will need to be applied as to the extent of any margin for prudence included in
the reserving basis and/or whether capital requirements should be allowed for explicitly.
The assumed reserving basis and capital requirements will also be an input to the profit
testing of the product.

As this is a new development, the model will be run several times to test the sensitivity of
premium rates and profit emergence to changes in assumptions. This is important data to
have available for the monitoring stage.

The actuary should be mindful of compliance with relevant regulation and professional
guidance when pricing the product.

The actuary will take account of the commercial and economic environment when deciding
on the resultant rates, for example by comparing the resultant rates with those available
elsewhere in the market.

Monitoring the experience

After the launch of the annuities the experience will be monitored regularly to determine
how it compares with the assumptions made at launch.

It may take time for significant volumes of data to build up, particularly if mortality
experience is being monitored by type of illness. The smaller the volume of business, the
greater the likely volatility of the experience.

If the experience differs markedly from the initial assumptions, revised assumptions may be
determined. The product will be profit tested once more, which may lead to a change in
premium rates. Deviations between experience and assumptions may also lead to a change
in the reserving basis.

The experience should be discussed with the underwriters as it may indicate

inconsistencies between the approaches taken by the underwriters and that assumed in the
pricing assumptions.

Changes to the premium rates offered by competitors will also be monitored to ensure that
the rates do not become uncompetitive. This may also lead to a change in the premium
rates. The monitoring of the ill-health enhancements offered by competitors may be difficult
as the approach taken to grouping illnesses may vary significantly between companies.

It is possible that the company finds that it cannot offer premium rates that are both
competitive and profitable, in which case it may withdraw from the marketplace. If the rates
appear too competitive it may be an indication that the standard mortality assumption or
ratings used are inappropriate, or that the market is not competitive, in which case larger
profits can be made.

You will notice that the Core Reading solution structures the answer around the first three stages
of the actuarial control cycle. However, professionalism and the general economic and
commercial environment have been covered within the developing the solution stage.

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Chapter 0 Summary
The actuarial control cycle
A fundamental tool for risk management.

Involves:
 analysing situations, products and projects to understand risk exposure
 quantifying consequences of risk events
 determining appropriate approaches to risk management
 monitoring situation and risk management procedures.

Steps of the process:

 the general economic and commercial environment
 specifying the problem
 developing the solution
 monitoring the experience
 professionalism.

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