The Actuarial Control Cycle

Actuarial Control Cycle (ACC)

The general Professionalism Specifying the problem Developing a Solution Monitoring

commercial and
economic environment
Actuarial Risk and risk Modelling Monitoring
Providers of Benefits advice management
Analysis of surplus
Contract design Data
Insurance products
Setting assumptions
Regulation Capital requirements
Pricing & financing
Asset classes
The external environment Provisioning

Economic influences Asset management

Surplus management

Capital management

Accounting, reporting

Clients an actuary can advise

1. Policyholders and prospective policyholders 2. Members of benefit schemes and their dependents
3. Members of investment schemes 4. Employers
5. Employees 6. Board of directors of an insurance company
7. Shareholders of an insurance company 8. Creditors of an insurance company
9. Trustees of a benefit scheme 10. Sponsors of a benefit scheme
11. Auditors 12. Investment fund managers
13. Sponsors of capital projects 14. Banks
15. Central and local governments 16. Regulatory bodies
17. Reinsurers 18. Professional advisors – lawyers, IFA

Types of advice an actuary can give FIR

 Factual: based on research of facts e.g. legislation.

 Indicative: giving an opinion without fully investigating issues e.g. in response to a direct oral question.
 Recommendations: researched and modelled forecasts, alternatives weighted, recommendations made consistent
with requirements, work normally peer-reviewed.
Areas an actuary can advise on for risks related to contingent benefits

1. Provide statistical support as to the likelihood or severity of the event

2. Appropriate assumptions to model these
3. The actuary can give advice on the benefits structure.
4. The actuary can analyse trends from the data and both look back in the past to see how experience has been borne
out, as well as making predictions for the future.
5. Provide funding/reserving and contribution advice based on the expected level and incidence of claims.
6. Can give advice on models that could be used to model the risk,
7. Using stochastic modelling to assess likely outcomes
8. Use of scenario testing to assess the outcome in extreme conditions (which a stochastic model might underplay).
9. Advice in assessing the strength of the sponsor/provider promise on the benefits being provided.
10. Advice in communication with stakeholders in relation to the risks.
11. Advice on risk mitigation options
12. Advice in designing the investment strategies to maximise returns but within the risk appetite.
13. Advice on matching of assets to liabilities
Factors pertaining to the external environment CREATE GRAND LISTS
1. Corporate structure 2. Regulation and legislation
3. Environment and climate change 4. Accounting standards
5. Taxation 6. Economic outlook e.g. interest rates, inflation
7. Governance 8. Risk management requirements
9. Adequacy of capital and solvency 10. New business environment
11. Demographic trends 12. Lifestyle considerations
13. International practices 14. Social and cultural changes
15. Technological changes 16. State benefits

How do each of these factors influence business?

Corporate structure

 Mutual societies: Profits belong completely to policyholders, better benefits for a lower cost, finance cannot be
readily raised, restricts products, and pricing can be approached using surplus distribution / lowering margins.
 Private / public proprietaries: Easier access to markets for finance, economies of scale, dynamic management,
competitive edge, dividend payments.
Regulation and Legislation

 In some countries, there are forms of insurance that are compulsory e.g. employer’s liability insurance.
 Regulations influence the type of product most suited to customer needs. E.g. limitation of charges on mutual funds
might make it more suitable than another product even if it has other disadvantages.
 Regulation of sales processes influence the types of products that are brought to market. The need for detailed
explanation to consumers may mean complex products are not marketed.
Accounting standards

 Influence employer’s provision of employee benefits and range of products marketed.

Tax

 Benefits: They could be received free of tax / excess of benefit over contribution can be taxed as income or capital
gain / entire benefit can be taxed as income.
 Contributions: There may be tax relief on contributions paid + tax on resulting benefits / contributions to be paid
from taxed income + tax relied on ultimate benefit.
 Accumulation of return: Provider may have to pay tax on investment income and capital gain on assets backing
financial products and schemes. Double taxation is avoided.
 Inheritance tax
Governance

 It is the high level framework within which a company’s managerial decisions are made.
 Encourages managers to act in the best interest of stakeholders by providing adequate remuneration incentives and
using non-executive directors to provide an impartial view.
 Guidance on governance is often developed by regulators and the government
Demographic trends

 Include increased longevity and falling birth rates.

 May result in an ageing populations which leads to:
- Increased strain on social welfare system and cost of healthcare.
- Decreased spending and cost of education.
Lifestyle considerations

 Younger people have a preference for loans rather than saving.

 People with children may have a need for life insurance protection products.
 Older people have a need for annuities and long term care products.
State Benefits

 Individuals may need to provide less for themselves. E.g. for an employer sponsoring a benefit scheme, he may
deduct any state benefits from the total benefit in order to minimise cost.
 There may not be a savings incentive. Individuals on a low income may find it more beneficial not to save at all as
any savings they have will offset state benefits and result in lower levels of income.
Cost of regulation
Direct costs: Indirect costs:
 Administration  Reduced product innovation
 Compliance of regulated firms  Reduced competition
 Moral hazard:
- Change in consumer behaviour because of a false sense of security
- Undermining professional responsibility of intermediaries
- Reduction in consumer protection mechanisms

Aims of regulation? GRIP

1. Give confidence in the financial system
2. Reduce financial crime
3. Inefficiencies in the market corrected and promote efficient, orderly markets
4. Protect consumers of financial products
Functions of a regulator SERVICE
1. Setting sanctions
2. Enforcing regulation
3. Reviewing and influencing government policy
4. Vetting and registration of firms and individuals authorised to conduct certain types of business
5. Investigating certain breaches
6. Checking prudential management and the way in which they conduct business
7. Educating consumers and the public
Need for a regulator
I. Information asymmetry
Anti-selection: Those who have more to gain from an option in a product are the most likely to exercise it
Moral hazard: Action of a party that behaves less carefully than they would otherwise if they were fully exposed
to the consequences of their actions

This can be dealt with as follows: CUNT D

1. Conflicts of interest: Knowledge held by a service provider about third parties can be restricted to public
disclosures by insider trading regulations and ‘Chinese walls’
2. Unfair features of insurance contracts: e.g. requirement of easy to understand language, not being able to
change contract terms, size and payment of surrender values etc.
3. Negotiation: The customer’s position can be strengthened by the right to terminate sales process or
providing a ‘cooling off’ period or include maximum levels of commission scales, premium rates, and
management charges.
4. Treating the customer fairly: Actuaries may have statutory responsibility to notify authorities if they believe
that a product provider is acting in a way that would prejudice the interests of the customers (whistle
blowing)
5. Disclosures and consumer education

II. Maintaining confidence SICCO

1. Stock exchange requirements: Fulfil criterial regarding financial stability, disclosures, new shares and
takeover bids, pricing
2. Integrity and competence: Obtaining specified qualifications or membership of professional organizations
3. Capital adequacy
 4. Compensation schemes: Schemes that provide recompense to investors who have suffered losses due to
fraud, bad advice, failure of the service provider
5. Other: Transparency in the marketplace
Regulatory regimes
1. Unregulated markets
2. Voluntary codes of conduct
Adv: reduced cost of regulation and expertise of participants
Disadv: incentive to breach with no legal backing
3. Self-regulation
Adv: expertise of participants, rapid response to market needs, cooperation
Disadv: selfish rules detrimental to consumers, low public confidence, inhibit new entrants
4. Statutory
Adv: safer, higher public confidence, economies of scale
Disadv: costly, inflexible, lack of expertise
5. Mixed
Each of these can be in the form of:
- Prescriptive: detailed rules setting out what may or may not be done
- Freedom of action: freedom of action but with rules on publicity so that third parties are fully informed
- Outcome based: freedom of action but prescribe outcomes that will be tolerated
Functions of the central bank
1. Determine or influence rates of interest, inflation and exchange
2. Lender of the last resort to commercial banks
3. Control the money supply in the economy
4. Target macroeconomic features such as growth and unemployment
5. Ensure stability in the financial system
Basic regulatory requirements of a stock exchange

 Adequate financial resources

 Traders and brokers on the exchange have adequate capital
 Proper rules for conduct of business exist, the parties are aware and understand them, monitored to ensure
enforcement to prevent insider trading and fraud
 Proper, transparent and sufficiently liquid markets in the securities traded
 Appropriate procedures for recording transactions: time, place, volume, parties
 Appropriate procedures for admitting new listings
 Fulfilment of accounting standards in order to secure and maintain listing
 Proper arrangements for clearing transactions
Areas of insurance that maybe regulated
1. Products e.g. to ensure ethical products and in the interests of the society in which they are made available
2. Nature of products e.g. company might be restricted to write only general or life insurance
3. Policy documents e.g. T&Cs should be fair to the customer
4. Sales literature e.g. should be realistic and not misleading
5. Product pricing e.g. to ensure premium is not inadequate for risk undertaken nor excessive due to limited
competition or increased demand
6. Sales process e.g. cooling off period, charges and commissions and distribution channels
7. Underwriting process e.g. gender neutral pricing
8. Claims underwriting process e.g. it is applied fairly to both the company and the policyholder
9. Reinsurance e.g. there is no arbitrage of regulation and counterparty risk is properly managed
10. Reserving e.g. to ensure prudence is maintained in calculation of reserves
11. Regulatory capital requirements e.g. to ensure funds are sufficient to meet benefits
12. Quality and mix of capital e.g. to protect customer interest and maintain confidence in the system
13. PRE in terms of areas where the insurer has discretion e.g. bonus rates, reviewable premiums
14. Investments and asset classes held to match cashflows
15. Insurance company systems and processes to maintain confidence in the system e.g. Chinese walls
16. Data confidentiality compliance
Challenges to the regulator in maintaining regulation
- The regulator needs to father sufficient evidence to justify action – failure to do so could result in legal action
- The regulator is dependent on the skills and expertise of the staff compared to the complexity and size of the
insurance market
- Principle based regulations might be open to interpretation by different companies
- Dealing with disputes and resolving them can be expensive and time consuming
- The regulators are dependent on the experience of supporting professionals like actuaries in third party
consultants
- Accuracy of information and the timely disclosure of results would be of utmost importance
- The system, process, people and governance might not be efficient and less effective during times of stress and
pressure
- There might be loopholes in regulation that take time to correct and implement
- Legislation changes could change financial structure for companies overnight and this could have serious
consequences.
- Operational risks e.g. a major catastrophe could occur that could bankrupt a company without giving the
regulator time to intervene to take steps
- If regulations or actions are too strict, companies might re-domicile to foreign markets
- Political pressure from government or consumer groups to adopt particular set of approaches
- The more stringent the level of regulation, the more restricted product range, prices too high etc.
Summary of life insurance products
1. Pure endowment
Provides benefit on survival to the end of the term
- operates as a savings vehicle, providing a lump sum on retirement
- means of repaying a loan

2. Endowment
Provides benefit on death during the term or on survival to the end of the term
- as a means of transferring wealth
- repaying capital on a loan
- operates as a savings vehicle, providing a lump sum on retirement
- A group endowment would enable an employer to provide benefits at retirement or death in service in respect
of employees.

3. Whole life assurance

Provides benefit on death whenever that might occur
- Providing funeral expenses
- Meeting liability to tax

4. Term assurance
Provides benefit on death provided it occurs within the term selected.
- Protection against financial loss for assured’s dependents
- Decreasing term assurance can be used for repay o/s balance under repayment loan
- Group term can be used by an employer to provide a benefit to dependants on the death in service of an
employee.
- It can also be used by a credit card company to provide a benefit on death equal to the balance outstanding on
a credit card.
- Any supplier of goods with instalment payments can use it to cover the risk that recovered goods are less
valuable than the outstanding loan balances due on death.

5. Immediate / deferred annuity

 A single premium (or consideration) purchases the income, which commences immediately after purchase.
Deferred annuities can be used when there is time between the date of purchase and the date when the income stream
is required to start. The contract can thus be paid for either by a single or regular premium during the deferred
period.
- Meet the financial needs of an income for remainder life or during a limited period
- A group version of the contract can be used by an employer to fund for pensions

6. Income drawdown
Instead of buying an annuity, the fund remains invested and the member withdraws an amount of the fund each
year. This may be just the income earned on the fund or may also include some of the fund capital.
- Should the member die before having to secure an annuity, the member’s heirs can inherit the balance of the
fund.
- The member may be able to earn a return in excess of that underlying annuity rates.
- The member has flexibility in terms of how much to take each year as an income.
- the administration charges may be high

7. Investment bonds
These are single premium contracts, normally whole life, designed to enable policyholders to invest for the medium
to long term. On death, the bond will pay a lump sum. They are typically written on a unit-linked basis. Used in a
similar way to investment drawdown products. A policyholder can usually make withdrawals from an investment
bond, however these may incur a penalty in the first few years of the bond.

8. Income protection
The contract enables individuals to provide an income for themselves and their dependants in the event of the insured
risk occurring. The most common insured risk is long-term sickness or incapacity due to accident or illness. These
contracts typically terminate at retirement age, and do not provide benefits for the first period of any claim.
- The group equivalent can be used by an employer to provide a sick-pay scheme for employees.

9. Critical illness
The contract provides a cash sum on the diagnosis of a ‘critical’ illness, such as heart attacks, strokes or many forms
of cancer, which could be used for nursing and other care.
- A group version of the stand-alone contract could be used by an employer to provide financial security for
employees in the event of contracting a critical illness.

10. Key person insurance

A life and / or critical illness policy taken out to cover the life of a key person within a business.

11. Long term care insurance

The contract can be used provide financial security against the risk of needing either home or nursing-home care as
an elderly person, i.e. post-retirement. The contract could pay for all the costs of care throughout the remainder of
life (an indemnity contract), or could provide a cash lump sum, or an annuity, to contribute towards the costs of
care.
- A group contract would enable an employer to provide long-term care cover to employees and their spouses
and parents.
Summary of general insurance products
- Short-tailed means that claims are generally reported quickly and settled quickly by the insurer, and
- Long-tailed means that there is a sizeable proportion of total claim payments that take a long time to be reported
and/or a long time for the insurer to settle.

 Employer’s liability
Indemnifies against the legal liability to compensate an employee for accidental bodily injury, disease or death
suffered, owing to negligence of the employer, in the course of employment. E.g. asbestosis

 Motor third party liability

 Indemnifies the owner against compensation payable to third parties for death, personal injury or damage to their
property. In most countries such cover is compulsory.

 Public liability
Indemnifies against legal liability for the death of, or bodily injury to, a third party or for damage to property
belonging to a third party, other than those liabilities covered by other liability insurance.

 Product liability
Indemnifies against legal liability for the death of, or bodily injury to, a third party or for damage to property
belonging to a third party, which results from a product fault. Here the perils depend greatly on the nature of the
product being produced, but include faulty design, faulty manufacture, faulty packaging and incorrect or misleading
instructions. E.g. unwanted side effects from a drug

 Professional indemnity
Indemnified against legal liability resulting from negligence in the provision of a service, e.g. unsatisfactory medical
treatment

 Pecuniary loss
Includes mortgage indemnity guarantee insurance and protects against bad debts or other failure of a third party.

 Fidelity guarantee
Covers against financial losses caused by dishonest actions by employees (fraud or embezzlement).

 Business interruption cover

Indemnifies against losses made as a result of not being able to conduct business for various reasons specified in
the policy, e.g. fire at the insured’s or a neighbouring property.

 Personal accident insurance

Benefits are usually specified fixed amounts in the event that an insured party suffers the loss of one or more limbs
or other specified injury. This is not indemnity insurance because it is not possible to quantify the value of the loss,
for instance, of an arm.

Characteristics of cash on deposit and money market instruments

 Security: depends on the issuer but in most cases due to short term nature, default is very rare
 Yield (real/nominal): Income will roughly equal prevailing short term interest rates thus giving a positive real return
as rates will be higher when inflation is higher.
 Yield (relative return): Low risk, low return.
 Spread: Nominal values are fixed in cash terms and as they are short term, there is very little volatility.
 Term: Short term (one year/ week/ day)
 Expense: Minimal
 Marketability: Except call and term deposits, excellent. Unquoted – traded through an interbank money market
 Tax: total return treated as income for tax purposes
When would long-term institutional investors such as life insurance companies and pension funds hold cash?

I. For liquidity Reh OR UK?

 Recent cashflows  Opportunities
 Risk aversion and preservation of nominal value of capital  Uncertain outgo
 Known short-term commitments

II. Temporarily, when taking a view that values of other assets are likely to fall. RUDI
- Start of an economic recession
Domestic market performs badly – share prices fall
Government borrowing increases – larger supply of bonds – reduction in price.
But, fall in short term interest rates – lower yields – higher prices
- General economic uncertainty
Stability of capital values for cash for risk averse investors
- Depreciation of domestic currency
Government raises short term interest rates – value of other assets will fall
Cash investment in stronger currencies could prove attractive even if rates abroad were lower
- Increase in interest rates
Gross redemption yields increase – price of bonds falls
Depress economy – reduce company profits – effect equity share prices
Characteristics of fixed interest bonds

 Security: Bonds from a reputable government have virtually no default risk

 Yield (real/nominal): If bonds are held until redemption, the nominal value of income and capital are known and
fixed. The actual return is uncertain if coupons are reinvested on unknown terms/ bond is sold before redemption/
real return is uncertain
 Yield (relative return): Low risk, low return. Holding bonds when yields are falling and buying bonds when yields
are high
 Spread: Market values change every day dependent on supply and demand. Quite large shifts are possible with less
liquid, long dated stocks
 Term: Short, medium, long, undated
 Expense: Dealing costs are really low
 Marketability: Excellent
 Tax: depends on the country’s regime
Fixed interest corporate bonds are less secure (dependent on type of debt, company and term), less marketable, more
volatile/less liquid, but with higher yields to compensate for these additional risks.
Index linked bonds provide a return in real terms (linked to inflation), are much smaller and hence less marketable. The
convention for quoting yields is to assume a fixed rate of future inflation and then calculate the real yield in excess on
this assumed rate. So, it is a fall in real yields (not nominal yield) that increases price.
Relative attractiveness of fixed interest and index linked bonds

 Bond yields will fall if investor expectations for future inflation falls or size of inflation risk premium falls.
These occur with minimal effects on real yields and thus have minimal change in index linked prices.
 An investor whose expectation for future inflation is lower than implied by the difference between nominal and real
yields in the market will find conventional bonds more attractive.
 Index linked bonds will increase in value as markets become more uncertain about future inflation.
Factors affecting bond yields / level of the bond market IT’S FIRE!
Bond yields are inversely related to bond prices
1. Inflation: Higher inflation – higher yield (reflects expectations theory)
2. Theories of yield curves
3. Short term interest rates:
- Short term bonds: interest rates fall – yields fall – prices rise
 - Long term bonds: (less clear cut)
Expectation theory: interest rates fall – market revised down – yields fall
Inflation RP theory: fall in rates - sign of monetary easing – expected long term inflation– rise in yield
4. Fiscal deficit (reflects market segmentation and inflation RP theory)
– leads to borrowing – rise in supply of bonds – lower prices - increased yields
– printing money – lower rates – increase expectations of inflation – rise in yields
5. Institutional cashflow: inflow of funds – increased savings – increase in demand – prices rise – yields fall
6. Returns on alternative investments
7. Exchange rates: Exp. return on Indian bond = Return on US bond + appreciation of $ against ₹
Short run: change in rates leads to change in exchange rate
Long run: exchange rate follows purchasing power parity – changes in inflation view might offset
changes in exchange rate views so there will be a strong link between US and Indian bond yields
Factors affecting short term interest rates
Short term interest rates are controlled by the government through central bank intervention. Central banks set short
term interest rates as the rate at which it is prepared to lend money in the market and this becomes the benchmark rate.
Other short term interest rates are agreed through supply and demand between money market participants.
The main reason they would alter interest rates are:
1. Economic growth: Low interest rates – increased investment spending by firms – increased consumer spending
2. Inflation: ‘Quantity theory of money’ states that there is a direct relationship between quantity of money in the
economy and level of prices of goods and services. If the amount of money were to double, prices would also
double, causing inflation. Low interest rates – demand for credit – increased money supply – inflation
3. Exchange rates: Low domestic interest rates – international investors less inclined to deposit – decreases demand
for domestic currency – reduces exchange rate.

4. Liquidity: There may be greater demand for cash in markets of poor liquidity causing interest rates to go up
5. Return on alternate asset classes: Likely to have less liquidity and hence unlikely to provide perfect alternative
to money market assets
Theories of the yield curve

Expectations theory: It helps predict what short term interest rates will be in the future depending on current long term
interest rates. The theory suggests that an investor earns the same amount of interest by investing in two consecutive
one-year bond investments versus investing in one two-year bond today. If interest rates are expected to rise, yields
would rise and the yield curve would slope upwards.
Liquidity preference theory: It suggests that an investor should demand a higher interest rate or premium on securities
with long-term maturities that carry greater risk because, all other factors being equal, investors prefer cash or other
highly liquid holdings. The yield curve should have a slope greater than predicted by expectations theory.
Market segmentation theory: It says that long and short-term interest rates are not related to each other. The prevailing
interest rates for short, intermediate, and long-term bonds should be viewed separately like items in different markets
for debt securities. It asserts that the buyers and sellers in different markets have different characteristics and
motivations, supply and demand affects yields. E.g. banks generally favour short-term securities, while insurance
companies generally favour long-term securities.
Inflation risk premium theory: It suggests that an investor should demand a higher nominal interest rate on securities
with long term maturities that carry a greater risk that inflation is higher than expected. The theory applies if it is assumed
that investors have real liabilities. It will also not apply to index linked bonds. The yield curve slopes upwards to reflect
the additional return on longer bonds.
What would an upward sloping yield curve reflect?

 Liquidity preference theory

 Investors expect increased inflation
  An expectation that real yields will rise due to:
- Reduced demand for investments in the future / reduced level of savings
- Reduced demand for index linked stocks
- Increased supply of investments in the future / increased borrowing / government deficit
- Increased supply of index linked stocks / government funding through conventional bonds reduced
Characteristics of equity

 Security: depends on the company – stability of profits and dividend cover

 Yield (real/nominal): Real yield over the long term. Profits rise with inflation and economic growth, so do dividends.
(not guaranteed)
 Yield (relative return): Higher than bonds – margins depend on company
 Spread: Equity prices and dividends can be volatile. Price depends on demand and supply, and present value of
future dividends
 Term: held in perpetuity
 Expense: closely linked to marketability i.e. for many shares, largest element of expense is spread between prices.
Dealing expenses are greater than for bonds.
 Marketability: Varies by company. Larger the company, better the marketability. Unlisted shares sold on ‘matched
bargain’ basis have poorest marketability.
 Tax: Income and capital gains from quoted shares may be taxed differently.

Why are shares often classified by industrial sector? What are the drawbacks? Suggest alternate classifications.

 Practicality DICE
- Decision making: grouping of equities using a common factor assist in portfolio management and classification
- Information: will come from a common source and presented similarly
- Correlation: factors affecting one company within the industry are likely to be relevant to others
- Expertise: Sector wise analyst expertise

 Correlation of investment performance RSM

- Resources: Use of land, labour, material will be similar – similar input costs
- Structure: Similar financial structures – therefore similarly affected by change in interest rates
- Markets: Similarly affected by changes in demand
Drawbacks:
1. Companies operate throughout several sectors – i.e. conglomerate companies.
2. Heterogeneity of companies within same sector e.g. due to size, or because they operate within different niches
of the market.
3. Analysts become less proficient at choosing between industries due to sectoral expertise
4. Although industry shares are correlated, overall market movements explain most of the share price movements
Alternate classification
1. Market capitalisation – larger companies may benefit from economies of scale, while smaller companies may
have greater potential for rapid growth
2. Location – companies based in a particular area suffer similar costs for premises and availability of labour
3. Price earnings ratio (or dividend yield) –Could group by high growth / stable / low growth.
4. Financial structure (gearing) – this indicates the potential volatility in earnings for shareholders on changes in
trading profit.
Factors affecting equity prices / level of the equity market IS DIRECT
1. Interest rates
- Low interest rates – increased economic activity – increased profits – higher prices
- Rate of return required will be lower – higher PV of future dividends
2. Supply:
-Number of rights issues - Share buybacks - Privatisations
3. Demand:
 -Taxation - Institutional flow of funds - Attractiveness of alternative investments
4. Inflation: Rate of dividend growth is expected to increase in line with inflation.
However, indirect effects might include
- High interest rates – fear of inflation – depressing effect on the economy
- Uncertainty leads to nervousness in the bond market – increased equity investment
5. Risk premium: depending on investor confidence, it is the additional return required to compensate for risk
6. Economic growth
7. Currency movements
Weaker currency – competitive exports – increased profits
Weaker currency – expensive imports – reduced profits – higher costs of raw materials – inflation
8. The expectation of profit
Characteristics of a prime property CALL ST

 Comparable properties available

 Age and condition
 Location
 Lease structure
 Size
 Tenant quality
Characteristics of direct property investment
1. Security: The security of income depends very much on the quality of the tenant. Rent payable by a company is a
prior charge on its profits, but costs of recovery from tenants in arrears can be high and there is a risk of ‘voids’ –
periods when the property is not let. Other risks are obsolescence and government intervention.
2. Yield (real/nominal): Property is a real asset and would therefore be expected to provide a hedge against inflation.
3. Yield (relative return): In comparison with index-linked government bonds, property is less marketable and less
secure. Investors would therefore be expected to require a higher return from property. The running yield (i.e. rental
yield) on property varies with the type of building. Property rental yields have often been lower than conventional
bond.
4. Spread: Capital values of buildings can be volatile over the longer term, although infrequent valuations and stable
valuation methods reduce short-term volatility. As land is indestructible, a good site is always likely to have some
value.
5. Term: Leases are for fixed terms with relatively infrequent rent reviews. These may be ‘upward only’. The income
stream might increase in steps every few years. The term of a lease may range from about five to over 100 years.
6. Expense: Property management costs are high, although the tenant is often responsible for building maintenance
and insurance.
7. Marketability: Property is very unmarketable. Dealing costs are high.
- Unit size of properties is usually large mostly indivisible
- Each property is unique so harder to value
- Valuation is a matter of professional judgement and there is no central market
8. Investment characteristics can be changed by the owner: E.g. redevelopment of an existing property or re-
negotiation of a lease with a sitting tenant.
Factors affecting property prices / level of the property market
1. Economic growth: increases demand for commercial and industrial premise – higher rents – higher values
2. Structural changes: e.g. trend of firms to move from expensive capital city locations to cheaper areas
3. Development cycle: It is fixed in location and takes time to develop. Results include surplus availability during
economic downturn and shortage when it improves.
4. Inflation: good hedge in the long run
5. Interest rates: higher rates – lower valuation of future rents – lower capital value. In the long term, high long
term bond yields push up property investment yields.
6. Residential property is entirely driven by supply and demand
Collective Investment Schemes / Mutual funds
 Open ended: Managers can create or cancel units in the fund as new money is invested or disinvested.
  Close ended: once the initial tranche of money has been invested the fund is closed to new money. After launch,
the only way of investing in an investment trust is to buy units from a willing seller.

Investment trust Unit trust

Type of scheme Close ended Open ended
Structure Public company Trust
Borrowing Can raise loan and equity capital Limited powers to borrow against portfolio
Price Share price determined by supply and Unit price is calculated daily as market value of
demand. A guide to what that share price underlying assets divided by number of units.
might be expected to be is the net asset value Complications include using bid/offer prices and
(NAV), which is the value of underlying allowing for expenses and charges.
assets divided by number of shares.
Parties involved Board of directors Management company
Investment managers Trustees
Shareholders Investors

Open-ended investment company (OEIC): An investment vehicle similar in corporate governance features to an
investment trust but with the open-ended characteristics of a unit trust.
My Unique TURING

Close ended schemes Open ended schemes

Marketability Less than underlying assets (unless Guaranteed by the managers
unmarketable assets like property)
Uncertain value At any point there might be uncertainty
as to true NAV per share, especially if
unquoted
Tax Might be different Might be different
Underlying asset volatility Shares are more volatile than underlying Volatility of units similar to that of
equity because size of the discount can underlying assets
change.
Return Higher expected return Lower volatility so lower return
Investment In a wider range of assets In a smaller range of assets
NAV/Price It may be possible to buy assets at less the unit price is fixed by direct reference
than net asset value in a closed-ended to the asset values
fund.
Gearing Makes share more volatile than Cannot be geared or can be to a limited
underlying equity extent

Advantages of mutual fund investments

 Specialist expertise  Diversification

 Direct investment costs are avoided  Holdings are divisible
 Tax advantages  Marketability
 Can track the return on a specific index

Disadvantages of mutual fund investments

 Loss of control
 Management charges
 Maybe tax disadvantages
Use of overseas investments
1. Matching liabilities in the foreign currency
2. Increasing expected returns due to high risk investments or via global market inefficiencies like currency change
3. Diversification
4. There might not be suitable assets available in the domestic economy
5. Tax situation might favour overseas investment
Problems related to overseas investments CATERPILLARS
1. Currency fluctuation risks
2. Additional administration function: custodian, dividend tracking and collection
3. Tax treatment: Overseas investment will often result in higher overall tax. Withholding tax is tax deducted at
source from dividends or other income paid to non-residents of a country.
4. Increased expertise needed: Extra variables to analyse
5. Restrictions on ownership of certain shares
6. Risk of adverse political developments
7. Less information may be available
8. Liquidity risk
9. Language problems
10. Different accounting practices
11. Poorer market regulation in some countries
12. Significant time delays
To overcome some of these issues, one can invest indirectly in overseas markets via:
- MNCs
 Adv: Easy to deal in familiar home market, expertise in profitable areas overseas
 Disadv: Earnings will be diluted, no flexibility for investor
- Collective investment schemes
- Derivatives
Factors to consider before investment in emerging markets
 current market valuation  possibility of high economic growth rate
 currency stability and strength  level of marketability
 degree of political stability  market regulation
 restrictions on foreign investment  range of companies available
 communication problems  availability and quality of information

Advantage of investing in emerging markets MED

1. Market valuation maybe cheap
 Pricing in developing economies might be less efficient resulting in anomalies allowing investors to
buy cheaply
 Perceived riskiness of investment lowers demand and prices
2. Economic growth
3. Diversification
Disadvantages of investing in emerging markets Restricts Communication And MRPS
1. Restrictions on foreign investments
2. Communication problems (language barriers and time delays)
3. Availability of information
4. Marketability
5. Regulation
6. Political instability
7. Spread / volatility
Required return vs. Expected return
Required return = risk free real rate of return + expected inflation + risk premium
- That value of investments do not decrease in real terms
- Additional compensation for giving up the use of cash
- Compensation required for undertaking risk for that investment
Risk premium depends on characteristics of assets and investor preferences (which is largely driven by liabilities)
 Expected return = initial income yield + expected capital growth

income growth + impact of change in yield

- Price paid for the asset
- Price the investor expects to sell / redeem the asset
- Expected income while holding the asset
If assets are priced fairly, required return = expected return. This is discussed in the capital asset pricing model (CAPM).
Return (asset) = risk free rate of return + beta * market risk
Factors influencing the long term investment strategy for institutional investors
Can Assets Compete On Risk & Return?

risk appetite
investment rules
Constraints legal / statutory
solvency
accounting
existing assets +size of assets

Assets, liabilities, matching cashflows future liabilities nature

term

matching cashflows currency

uncertainty
Competition's strategy
meeting liabilties as they fall due

Objectives of the institution control incidence of future obligations on third party

Risk diversification

taxation

Return expenses

long term expectations

Factors influencing the long term investment strategy for individual investors

Assets, liabilities, matching Risk Return Constraints

cashflows
variability taxation Investment
Assets
•Excess assets
•current wealth + future income diversification expenses •Uncertainty
Liabilities feel good •Risk appetite
•debt + future spending factors

Matching cashflows Practical

•nature •lack of assets for direct investment
•term •lack of knowledge
•currency •high relative expenses (eos)
•uncertainty •lack of access to research facilities
•less time available
•can't take advantage of
opportunities on short notice
Principles of investment
The principles of investment for a provider of benefits on future uncertain events can be stated as follows:
a. A provider should select investments that are appropriate to the nature, term, currency, and uncertainty
of the liabilities, and the provider’s appetite for risk.
b. Subject to (a) the investments should also be selected so as to maximise the overall return on the assets,
where overall return includes both income and capital.

Cashflows for an annuity

Investor: (-) (+) (+) (+) …
--------------------------------------------------------------------------------------------------------------- >
0 1 2 3 4 5 6 7 8 9 10
(Purchase) annuity payments (Deferred/immediate? Guaranteed? Term? Real/fixed?)

Annuity provider: (+) (-) (-) (-) …

--------------------------------------------------------------------------------------------------------------- >
0 1 2 3 4 5 6 7 8 9 10
(Sold) annuity payments and expenses
Investments + returns
Cashflows for a repayment loan (mortgage)
(Almost entirely interest) (Almost entirely capital)
Loan taker: (+) (-) (-) (-) …
--------------------------------------------------------------------------------------------------------------- >
0 1 2 3 4 5 6 7 8 9 10
(Loan) loan repayments (Fixed/ varying rate? Early repayment option?)

Loan provider: (-) (+) (+) (+) …

--------------------------------------------------------------------------------------------------------------- >
0 1 2 3 4 5 6 7 8 9 10
(Loan) loan repayments

Nature of liability cashflows

Benefit payments - premium income

+ expense outgo
Investment-linked
Monetary (fixed) Real (index)
Guaranteed - monetary terms
Guaranteed - earnings/index
Discretionary
How do you select assets based on the nature of liabilities?
1. Guaranteed in monetary terms
a. Pure matching: both in terms of timing and amount
b. Approximate matching: if options exist, pure matching cannot be realistically achieved. The best match
can be achieved using high quality fixed interest bonds of suitable term. Alternatively, use derivatives.
2. Guaranteed in terms of index
The most suitable match is index linked securities. In their absence, equity type investments can do.
3. Discretionary benefits
Investing in assets that produce highest expected return subject to expectations and risk appetite of investor
4. Investment-linked
Investing in the same assets as used to determine benefits. Replicating market index may involve holding a large
number of small holdings and thus be too costly. So using CIS or derivatives might be better.
If the provider holds free assets or surplus, he can depart from the matching strategies above to improve overall return
instead, and benefit clients through higher benefits or lower premium rates and shareholders through higher dividends.
Regulatory influences on assets held TECH SCAM
1. Type of assets the provider can invest in 2. Extent to which mismatching is allowed
3. Currency matching requirement 4. Holding specific assets e.g. government bonds
5. Single counterparty maximum exposure 6. Custodianship of assets
7. Amount of one asset used to demonstrate solvency 8. Mismatching reserve

Active vs. Passive investment management

Active investment management Passive investment management

Restrictions Fewer restrictions on choice of investment Little freedom to choose investments
Choice of The manager makes judgments regarding future The manager holds assets closely reflecting those
investment performance of investments underlying a benchmark or index
Switching Likely to involve constant switching Portfolio is changed only in response to changes
in constituents of tracked index
Returns Expected to produce higher returns by Produces returns in lines with tracked index
identifying sector or stock selection profits
Efficient Appropriate only if investor believes investment Passive management is more suitable to an
market market is inefficient efficient investment market
Expenses Extra costs for more regular transactions Less expensive
Risks The manager judgement could be wrong Index may perform badly or there maybe
tracking errors.

Risks inherent to position of investment portfolio

 Strategic or policy risk: It is the risk of poor performance of the strategic benchmark relative to the value of the
liabilities.

 Active risk: Within their guidelines, the investment managers have freedom over stock selection, and use their
skills and research to maximise the return on the funds allocated to them. The allocation of this part of the
investment risk budget is known as the active (or manager or implementation) risk.

 Structural risk: There may also be some structural risk associated with any mismatch between the aggregate of
the portfolio benchmarks and the total fund benchmark.
Monitoring the investment performance and strategy

 The liability structure may have changed

 The free assets or funding position may have changed
 The manager’s performance maybe significantly out of line
 Change in the government’s position or regulations
 Change in business focus or commitments
 New asset classes might have been introduced
  Economic environment might have changed
 Regulatory requirement to review from time to time
 Change in risk appetite
Non-economic factors that affect demand for different asset classes

 Investors’ perceptions of the characteristics of the asset class i.e. risk and expected return
 External factors
o Investors’ incomes
 institutional most important
 private less important
 overseas allowable investment may have increased
o Investors’ preferences
 a change in their liabilities
 a change in the regulatory or tax regimes
 level of supply of an asset class
 risk appetite
 ethical concerns
 uncertainty/changes in the political climate
 “fashion” or sentiment altering
o Miscellaneous
 marketing/investor awareness of asset class
 level of understanding/education of asset class
 e.g. investor may receive education undertaken by the suppliers of a particular asset class
 emergence of new asset classes
 emergence of new technologies to trade/research/monitor asset classes e.g. online
o Price of alternative investments
o Expenses of trading
o Ease/speed/mode of trading
Reasons why performance of business funds might be out of line with other similar funds

 Funds may have different mandates from those of the funds considered to be similar.
 The investment strategies may be different – investment outlook might be different
 The risk they are able to take may be different.
 There may be different constraints on the funds
o On the use of derivatives
o On investments overseas (a narrower or a broader range or even none)
These could give rise to currency as well as performance differences.
 These funds may have different charges from those of other funds.
 Funds might be allocated in different countries
 The sizes of the funds may be different which may lead to different investment opportunities.
 The cash flows may be different which may have influenced performance. This could have restricted the funds
available for investment or led to disinvestments that may not be timed as well as would otherwise be the case.
 Poor stock choice / asset allocation
 Different method of measurement (net/gross, TWRR/MWRR etc.)
 The funds are actively managed, and therefore tracking error is expected
o different sector selection
o different stock selection within sectors
 Inconsistencies in the benchmark e.g.
o a change in underlying constituents
o or lag in collection and publication of data
Measuring different investment risks
1. Tactical asset allocation: Risk of following an active investment strategy
 a. Historical tracking error: Annualized standard deviation of the difference between the portfolio return and
benchmark return based on past observed related performance
b. Forward looking tracking error: Estimate of standard deviation of return relative to benchmark if its current
structure were to remain unaltered. (derived in quantitative modelling techniques)
2. Strategic asset allocation risk: Risk of poor performance of strategic benchmark relative to value of liabilities
The manager will be given a target range of asset allocation as a percentage of a fund. The risk can be measured
using forward and backward looking approaches assuming the relevant parts of the portfolio were invested in the
appropriate benchmark indices and the effects of actual strategic allocation compared to the target.
3. Duration risk: The investments maybe too long for liabilities (liquidity risk) or too short (reinvestment risk)
The tracking error techniques can be used to measure risk taken by departing from target duration
4. Counterparty, interest rate and equity market risk:
Best proxy to quantify the risk being taken is to use the amount of capital that is necessary to hold against the risk
and then calculate the required capital for a target vs actual portfolio.

Analysing investment performance against a benchmark

I. Comparative performance
a. Input all the cashflows in and out of the fund onto a spreadsheet that also holds the daily values of the
benchmark. So we can readily calculate value of the fund over a period if it had been invested in the
benchmark instead.
b. If index includes income reinvested, dividends and interest are excluded as cashflows. If benchmark is
capital only, then the actual income from assets needs to be included.
c. There must also be an allowance for fees.
d. A decision regarding frequency of monitoring is to be made. Regular enough to achieve objectives to be
confident but mindful of expense.
e. Analyse reason for departure from benchmark performance
f. Performance an overall investment strategy might also be monitored related to a liability benchmark

II. Time weighted and Money weighted rates of return

They are methods of measuring performance or rate of return on an investment portfolio

a. MWRR / IRR: Discount rate at which PV inflows = PV outflows allowing for all cashflows and their
timings. It only takes into account new money. The formula places weight on the performance in periods
where account size is highest. If a manager outperforms a benchmark for a long period where account is
small and then has a short period of underperformance with a higher account value, MWRR may not reflect
the manager value correctly
b. TWRR: It is the product of growth factors between consecutive cashflows. To judge the manager fairly,
this is used. It is not sensitive to contributions/ withdrawals. It only accounts for new money.

III. Collective investment schemes

Factors that a company should consider before deciding to adopt an unmatched strategy

 Should be allowed by regulation

 Should take into account that even if current regulations allow mismatching, there’s a possibility of a revision in
regulation in the future to protect policyholders
 Need to consider available capital. Additional capital for mismatching will need to be held.
 Capital will need to be held in safer assets with low returns
 Would be difficult to factor in the additional CoC for annuities as they are highly price sensitive
 Alternative use of capital needs to be considered. E.g. for new business strain / merger or acquisition
 Financial strength of the company. Weaker cos. will not be able to invest in certain assets like direct property
 They might be unable to achieve sufficient diversification to offset the additional risks of an unmatched approach
 Financial results of the business will be more volatile and difficult to explain
 It will need to be confident that any financial backers would be happy with the approach and in line with risk
appetite.
 Insurer may want to generate higher investment returns from the unmatched strategy to charge more competitive
prices. It may also look at what other competitors are doing in the market.
 it will need to evaluate any alternative strategy against a benchmark of the matched position
 It will need to be fairly confident that its investment profits will be greater than could be obtained from a matched
strategy. There will need to be a significant enough excess return potential to compensate for the issues discussed
above.
 Need to consider:
o available/likely investment return on alternative assets
o excess return is available compared with likely increased risk/volatility
o expense - alternative strategy will be more active compared with matching strategy that would be more
passive
o altered tax position
o extra governance to monitor

Why is capital required?

Individuals:

 To survive financial consequences of unexpected events

 To save for a large future expense
 Allows people to overcome timing differences between income and outgo
 Accumulated capital provides a cushion for a future fall in income e.g. at retirement
Companies

 To deal with financial consequences of unexpected events

 Provide a cushion against fluctuating trade volumes
 Build up funds prior to a planned expansion
 Trading companies need capital for cashflow management to finance stock and work-in-progress
 Start-up capital to finance staff salaries, obtain premises, purchase equipment etc.
Providers of financial service products

 Need for capital to pay benefits on future financial events

 Allows for timing differences in expenses paid and charges earned
 Start-up and development expenses like for setting up management systems, collecting premium, paying
commission, investment expenses and administration expenses
 As per statutory or solvency requirements
 If a provider does not hold assets that match liabilities, movements in the market can result in liabilities
overtaking assets- capital will be required to provide a cushion
 For products with guarantees, to cover risk of being in the money at exercise date
 To exhibit financial strength
 Capital management can be used to smooth financial statements and improve solvency and matching
position of their balance sheet
 Impact acquisition, mergers and new opportunities
The State
State organizations usually do not need capital build up as they can borrow money or print money.

 To support fluctuation in balance of payments and in the economic cycle

 Short term funds to overcome timing differences in income and outgo

Why different schemes might use different assumptions in setting their funding level
1. Different membership profiles and maturity
2. The structure of the scheme membership can have an effect on the assumptions used.
a. For example, a scheme that is closed to new members will have a membership that will grow older as
members retire, leave or die.
b. Conversely, in an open scheme with a large active membership, it is likely that leavers will be replaced with
new recruits, and thus that the average age of the active membership will be broadly unchanged. This
assumption may generate a different future contribution rate than for the closed scheme.
3. Different demographic characteristics of the scheme memberships. For example the longevity assumptions may
vary significantly due to occupation, regions and socioeconomic groups.
4. Some schemes may have more knowledge about their membership (relating to health) than others.
5. One scheme may have a large number of smaller pensioner liabilities, versus a scheme with very few members with
large pensioner liabilities.
6. Investment strategies may be very different
7. Some schemes may adopt a matching approach, others may not
8. One scheme may have a prudent investment strategy involving mainly bonds compared to another scheme more
heavily invested in equities.
9. Investment strategies containing large hedging holdings may reduce the importance of specific assumptions.
10. The schemes could be using different methods for valuing the underlying assets within the investment assumption.
For example, one scheme could use market values and another could discount cash flows.
11. Scheme size may differ.
12. May also affect the quality of data available. Do they have their own data or will they need to use general data?
13. Strength of the backing employer, a strong employer may allow trustees to set a less prudent overall basis.
14. The funding approach may differ. For example, some employers may be funding in advance and others just in time.
15. The trustees could also be aware of special one off profits that could be allocated to the pension scheme meaning
they can differ on assumptions
16. Different measures of inflation in the scheme rules needing different assumptions.
17. Some schemes may have caps/floors within their benefits and these could be valued differently.
18. There may be different assumptions relating to salaries if schemes operate in different industries
19. The scheme may have valuable guarantees and options attached.
20. Some schemes may provide additional benefits. For example, could provide benefits to spouse. May be different
percentages involved.
21. Some trustees may consider some risks more concerning than others and therefore produce more prudent
assumptions.
22. The trustees’ actuarial advisors may have differing views on the assumptions. For example expected rates of return
on asset classes or longevity. This could be because of differing models to assess these risks or via judgement on
use of models available e.g. CMI.
23. The scheme could have differing views on the measures such as bond yields, noting that pension schemes are
generally long term in nature.
24. The scheme may have different legal views on the benefit specifications and approaches to equalisation as an
example this could have material impacts on the funding level requirements of the scheme.
25. The regulator may give guidance on the assumptions to be used and these could be interpreted differently – in
particular on how to value assets.
26. The schemes expenses may differ and hence there are different methods/assumptions for allowing for these in the
funding level.
27. The scheme may have differing aims from the funding level, one could be trying to achieve de-risking activities
over time and hence deliberately holding prudent (buy out) funding levels to try and enable decisions to get to this
level over time.
28. Indeed one scheme may have already partially insured benefits and valuations are being used for this element of the
scheme.

Differing capital requirements for a multinational company vs. an individual domestic company

 Domestic company is likely to only have one supervisor.

 If all business is written through one company this will have the least capital transferability and substitution
constraints as all the capital will be within the one company.
 A single supervisor will have responsibility to balance how it applies its regulations across all the entities of a group
it directly supervises.
 Domestic company will have less diversification resulting in more volatile experience and relatively higher capital
requirements
 If parent company is European, Solvency II regulations apply to European insurance companies and European
insurance groups. (at group level)
 Subsidiary will also need to satisfy their domestic capital and solvency requirements. These requirements may well
be different and may require different level of reserves and have different permitted assets. The local assets available
to invest in may also be different.
 The regulator will want to ensure that capital above standard capital requirements is maintained by the subsidiary
so that the company can withstand a level of adverse experience without recourse to its parent. This means that
capital above the standard capital requirement will be restricted reducing the capital available to the parent.
 In times of stress within the parent the capital that can be made available to the group may be further reduced as
the subsidiary’s regulator may take a more conservative approach on permitted dividends.
 In times of stress the transferability of capital within a group is reduced. The individual insurance company
supervisors will prioritise the individual company they have responsibility over other companies within the group.
 The relative behaviour of the capital standards will change over time due to their different design.
 The subsidiary business, although similar, may be slightly different. The products sold may be different and the
risks covered could be different. These would lead to different capital requirements.
 Currency issues my lead to different capital requirements e.g. mismatch reserve needed.

How providers meet, manage and match capital needs

Insurance companies

 Proprietary companies can raise funds through issue of shares or debt securities to existing or new
shareholders
 Mutual companies have less access to capital markets. They need start-up capital without the requirement
for the loan to be repaid unless profits emerge. They can raise capital through subordinated debt where
repayment is subordinate to creditors and policyholders.
Sponsors of benefit schemes

 Maybe prepared to put up initial capital

Micro insurance providers

 May have capital support from the state

Reinsurance can reduce the amount of capital required. It can also act as a source of capital. They can contribute towards
the initial capital strain by contributing to initial expense by means of reinsurance commissions. This is nothing but
financial reinsurance.
Capital management tools
1. Financial reinsurance (FinRe)
It is more motivated by financial aims and focuses less on transfer of risk compared to other forms of reinsurance.
The main aim is to exploit some form of regulatory arbitrage in order to manage the capital, solvency or tax position
of a provider more efficiently. It relies on the position of the reinsurer (which may be based overseas) being different
from that of the provider.

E.g. In a normal loan, the company’s assets would increase but so would the corresponding liability to repay. In a
contingent loan from the reinsurer to the reinsured, repayments are contingent on e.g. the insurance company making
profits in the future on a block of business. The insurance company has no liability to repay unless profits emerge,
so regulation might allow it to not make provision for this on a statutory basis. Solvency position improves. (As the
company will repay overtime, the improvement is short term)

The arrangement relies on the reinsurer having a strong enough balance sheet to be able to support this or being
subject to different rules on solvency reporting as otherwise they would see a deterioration in their solvency position.

The viability of FinRe is reduced under regulatory regimes like Solvency II which take credit for future profits. It
can still be used to change an illiquid asset (future profits) to liquid asset (reinsurance money) and so can help with
liquidity management.

2. Securitisation
It converts illiquid assets in tradable instruments to achieve regulatory or accounting ‘off balance sheet’ treatment.
It includes an element of transfer of risk associated with the value of assets. This results in any potential loss of
value of asset being capped.

Any asset that produces a reasonably predicted income stream can be used as a basis of a securitisation e.g. future
profits, mortgages into tradable instruments (bonds). The owner of the asset will issue bonds to investors
(pension/insurance companies) and the future cashflows generated by the asset is used to meet interest and capital
 payments on the bonds. The element of risk transfer includes contingencies like repayments are made only if future
profits emerge or mortgage repayments are made.
Like FinRe, they are less effective in regulatory regimes that take credit for future profits.

3. Subordinated debt
As with securitization, subordinated debt does not need to be included as a liability but improves free assets. It can
only pay interest or capital if regulatory capital solvency requirements will continue to be met after interest is paid
or if authorised by regulator. In the event of wind up however, subordinated debt will rank behind policyholder
liabilities including non-guaranteed bonuses.

4. Banking products
(i) Liquidity facilities: Provide short term financing for companies facing rapid business growth.
(ii) Contingent capital: Cost effective method of protecting capital base. Capital would be provided as and when
it was needed following a deterioration of experience. They improve financial strength of the insurer and
can be given credit for by a rating agency, but they lack visibility.
(iii) Senior unsecured financing: The loan would be treated as a liability on the balance sheet. It can be more
cost effective on a group level than other forms of financing.

5. Derivatives
They can be used to reduce risk or increase risk to improve returns. When the insurer is concerned about fall in
value of its equity portfolio, it can buy a put option or sell futures to protect the portfolio falling below a certain
level.

6. Equity capital
Increasing equity increases assets without increasing liability. It could come from the parent company / from existing
shareholders via a rights issue / from the market by placement of new shares

7. Internal sources of capital

This includes reorganizing the financial structure in a more efficient way.
 Merging funds: This could help if some of the regulatory liabilities or solvency capital was calculated as a
monetary or fixed amount per fund or had a fixed minimum
 Changing assets: If asset that is not admissible for regulatory purposes was switched out for one that was,
it would improve regulatory available capital position. A change in assets might result in closer matching
and reduce mismatching reserve required, hence freeing up some capital
 Weakening of valuation basis: Reduce the value of liabilities relative to the assets improving solvency
positon (acceptable only if can be justified)
 Deferring surplus distribution to policyholders (bonus) reduces level of guaranteed benefits and hence
capital required. Guarantees increase level of risk and hence capital needed to protect against adverse
outcomes
 Paying out lower or no dividends will retain capital but might have adverse effect on share price.
What is a model? What are the approaches to modelling?
A model is a cut down simplified version of reality that captures essential features of a problem and aids understanding.
When faced with an actuarial problem, one can

 Purchase a commercial modelling product

 Reuse an existing model after modification
 Develop a new model
The merits of each of these approaches depends on: FACET
 Desired flexibility of the model  The level of accuracy required
 Cost of each option  The in-house expertise available
 The number of times the model is to be used

Constructing an actuarial model

Operational Type: deterministic /

Objective Dynamism Development
issues stochastic / combination?
1. Objective: The model should be fit for the purpose for which it is being used.

2. Operational issues: CODED For Joint Methods

 Complexity: The model should not be overly complex so that the results become difficult to interpret and
communicate or the model becomes too long and expensive to run.
 Outputs: The outputs from the model should be capable of independent verification for reasonableness and
should be communicable to those to whom advice will be given.
 Documentation: The model should be adequately documented so that key assumptions are understood and
it can be run by other members of staff.
 Easy to communicate: The workings of a model should be easy to appreciate and communicate. The results
should be displayed clearly.
 Development: The model should be capable of development and refinement – nothing complex ca be
successfully designed and built in a single attempt.
 Frequency: The more frequently cashflows are calculated the more reliable the output but with the danger
of spurious accuracy. The less frequently cashflows are calculated the faster the model can be run.
 Joint behaviour: The model should exhibit sensible joint behaviour of model variables. The assumptions
should be consistent.
 Methods: A range of methods of implementation should be available to facilitate testing, parameterisation,
and focus of results.

3. Type of model: stochastic / deterministic / combination of both?

Deterministic model Stochastic model
 Parameter values are fixed  Estimates atleast one of the parameters by assigning
it a probability distribution
 Result is a single outcome  Result is a range of values giving the likely
distribution of outcomes
 More readily explicable to non-technical audience  Quality of the result is far superior
 Clearer as to what economic scenarios have been  Tests a wider range of economic scenarios
tested
 Sometimes no direct formula without use of  Depends on the legitimacy of the parameters and
probabilities is available assumptions
 Cheaper and easier to design, quicker to run  More complex programming with longer run time

A combination of the two can be used e.g. when pricing a life insurance policy with investment guarantee
attached, one might use a stochastic investment model but model fluctuations in mortality rates
deterministically.

4. Dynamism
The asset and liability part of the model and the assumptions should be programmed to interact as they would in real
life under various circumstances e.g. inflation and interest rates are consistent.
5. Development of the model
 Specify the purpose
 Collect, group and modify the data
 Identify parameters
 D: Ascribe values to the parameters using past experience and estimation techniques
S: Choose a suitable density function for each variable
S: Specify correlation between variables
 Construct a model based on expected cashflows
 Test the model to identify and correct build measures
 Check that the goodness of fit is acceptable
 D: Run the model using estimates of future values of variables
 S: Run the model each time using a random sample from chosen density function
 Produce a summary of results
Use of models

 To set premiums for a new product

 To monitor appropriateness of rates at regular intervals
 Check that business is profitable
 Ensure rates remain competitive
 Check that rates are appropriate for all groups
Selecting model points and rate of discount
The number of model points will depend on
- Computing power available - Time constraints
- Heterogeneity of the class - Sensitivity of the results
- Purpose of the exercise

The risk discount rate could allow for the return required by the company + the level of statistical risk (assessed
analytically, using sensitivity analysis, from a stochastic model, or by comparison with market data).
Or a stochastic risk discount rate could also be used.
Sources of data TRAINERS
1. Tables e.g. mortality IALM 2. Reinsurers
3. Abroad i.e. from overseas contracts 4. Industry data
5. National statistics 6. Experience investigation on existing contracts
7. Regulatory reports + company accounts 8. Similar contracts

Risks associated with using data I 2HOPE AF

1. Insufficient historical data available to estimate the extent and likelihood of risk
2. Historical data might not be a good reflection of future appearance due to
 Past abnormal events
 Significant random fluctuations
 Future trends not being reflected significantly in past data
 Changes in the way data was recorded
 Changes in the balance of homogenous groups underlying the data
 Heterogeneity within the group
 The past data might not be up to date
 Social, economic and medical changes
3. Risks associated with broad homogenous grouping as:
 Individual data groups might be too small
 If data groups are merged, the combined data might not be sufficiently homogenous
4. Data from other sources (e.g. industry) may not be a sufficiently good proxy for the risk assessed.
5. The available data may have been collected for other purposes, they might not be appropriate for current use
6. Errors / omissions in current data
7. Insufficient data for very adverse circumstances
8. Available data might not be in a form that is appropriate
Algorithmic decision making
Advantages: Risks: SAFE
- Increased speed - In very turbulent conditions, trading maybe suspended
- Facilitates execution of complex trading strategies before algorithmic trade can be completed
- Lower dealing costs - May not operate properly in adverse circumstances
- Efficiency of trading - Possible impact of the financial system
- Error in the algorithm or data used
Main uses of data
1. Administration 2. Accounting
3. Marketing 4. Premium rating, product pricing, contributions
5. Provisions 6. Experience analyses
7. Investment 8. Risk management
9. Management information

Checks on data
1. Verifying current data by performing reconciliations e.g. looking at membership movements during revaluation
periods, changes in average salary over time, individual records etc.
2. Use accounting data that provide information about the value of assets and benefit outgo/ premium collection. Use
of audited accounts will place greater reliance on data.
3. Asset data should be checked to see if they are permitted or subject to valuation restrictions. Can be cross checked
with investment management reports and sale-purchase details from managers.
4. Assertions such as whether a liability exists, whether asset is held on a certain date, timings of cashflows, data is
complete, appropriate value of investments recorded need to be checked.

Possible checks for these assertions could include: MIDBURN 2CS

 Movement of data should be checked against accounts e.g. for benefit payments
 Consistency between investment income implied by asset data and corresponding totals in accounts
 Checking title deeds to large real property assets including location/type/term/maintenance duties/restrictions
on use.
 Reconciliation of benefit amounts and premiums + changes using previous data
 Check unusual values like impossible dates of birth / retirement years etc.
 Random spot checks for individual members / policies
 Reconciliation of total number of policies / members using previous data
 Consistency between salary related contributions and in payment benefit levels as shown in accounts
 For assets held by third parties, reconciliation between owner’s and custodian’s records
 Consistency between average sum assured should be sensible and in line with previous investigation
 Consistency in shareholding between start and end of the period after adjustments
Industry wise data collection scheme
Potential benefits:
1. Insurer can compare its own experience with that of the industry as a whole by overall level and pattern of experience
by data categories. Any differences can then be earmarked for explanation.
2. Since an insurer is likely to be seeking to expand by attracting business from its competitors, might be important to
have an indication of characteristics of business it is seeking may differ from existing business.
Problems:
1. Heterogeneity in data arising due to differences in
a) Geographical areas b) Types of policies sold
c) Sales methods d) Underwriting / claim settlement standard practice
e) Nature of data stored f) Risk factors used
2. Less detailed/flexible data than that obtained internally
3. Out of date
4. Depends on quality of data systems of each contributor – mistakes by one company can invalidate data.
5. If all companies do not contribute, it might not represent industry as a whole
Considerations while setting assumptions LUNCH
- Legislative or regulatory constraints
- Use to which the assumptions will be put
- Needs of the client
- Consistency between various assumptions
- Having the most financial significance
Historical vs. Current data for information in setting assumptions
Historical data is likely to be a primary source of data
Demographic assumptions include
- levels of mortality
- number of individuals who will survive to receive pensions
- contingent benefits payable
- producing graduated decrement tables
- future improvements in mortality
- probability of becoming ill / retiring / leaving employment / getting married
Economic assumptions include
- to determine future investment returns by using past data on dividend yield on equity
- salary levels in a particular country
- where yield is linked to inflation, data related to inflation index
Current data might also be useful to determine assumptions
- relationship between current yields for fixed interest and index linked bonds might indicate market view of
future levels of inflation
- policy statements by government or banks
- a scheme sponsor may provide information on planned future salary increases or likely rates of withdrawal
- defined in regulations or legislation
Credibility of using past data to set future assumptions BEST ARCHER
1. Balance of homogeneous groups may have changed
- Past levels of salary growth may reflect a change in overall composition of workforce (production line workers
being replaced by mechanisation) rather than just changes in real salary levels
2. Economic situation may have changed
- Change in economic and fiscal policy / general cycle / investment returns / salary / dividend yields
- Past levels of an index to measure inflation fluctuates greatly – better to use current risk free real returns
3. Social conditions
4. Trends
- Withdrawal rates for benefit schemes depend on employee turnover (low during economic recession)
- Mortality improvements due to medical advances
5. Abnormal fluctuations
- Significant returns in one year on a specific asset could be because of government intervention
- High number of deaths due to an epidemic
6. Random fluctuations
7. Changes in regulation
- Changes in taxation of products
8. Heterogeneity within the group
- In a pension scheme, workforce might consist of manual labour, clerical staff, and management. These groups
have different levels of mortality, turnover, salary growth etc. The information needed to split the data reliably
is unlikely to be available.
9. Errors in data
10. Recording differences
- Statistics produced by the state or data recorded by companies might change
Profit criteria used to summarize profitability of financial contracts
1. Net present value (NPV): Expected present value of future cashflows discounted at the risk discount rate.
Advantage: Given a choice between projects, economic theory dictates that the investor should choose that with
the higher NPV
 Disadvantages:
o Not a very simple measure to present to non-technical people
o Depends on the assumption that the market is free and efficient
o Depends on the assumption that the discount rate correctly identifies riskiness of the product
o By itself it tells us little, needs to be expressed as a ratio to be meaningful
2. Internal rate of return (IRR): The discount rate at which NPV is zero
Advantages:
o Simple to calculate
o Compatible with shareholders who say they want return of atleast x%
o Easily comparable with other forms of investment
Disadvantages:
o It might not be unique
o It might not exist
o It is difficult to relate to other measures e.g. premium income
3. Discounted payback period (DPP): The earliest policy duration at which the accumulated value of profits is zero
Advantages:
o Useful means to compare products if capital is a particular problem
o Easy to explain as a break-even point
Disadvantage: It will often not agree with NPV as a means of deciding between two different sets of cashflows
because DPP ignore cashflows subsequent to DPP itself.
Reports accompanying accounts CIRCUS
Chairperson's Corporate
Investment Remuneration Uncertainty /
and CEO's governance Strategic report
report report Risk report
statements report
• Performance • Summary of • Pay of executive • How the • Attitude towards • Long term and
against key investments and non company is risk short term
objectives strategy and executive organized in • Key risks objectives
• Changes at board performance directors terms of board • How the • How they have
and senior • Attendance at and board company been met
management board meetings committees manages and • Progress on long
level • Turnover of • Statements on mitigates risk term objectives
• Idea of whether directors independence of • Performance
company is board against key
flourishing or not performance
- details of indicators
successes in the
year
• Merger and
acquisition
activity
• Unusual claims
experience
• Exceptional
expenditure

Benefit scheme related information that should be disclosed in accounts DIM CLAIMS
1. Director’s benefit costs
2. Investment returns over the year
3. Membership movements
4. Change in surplus / deficit over the year
5. Liabilities accruing
6. Assumptions
7. Increase in past service liabilities
8. Method
9. Surplus / deficits
Different bases to set assumptions
Best estimate: The set of assumptions that has equal probability of overstating or understating the values.
Optimistic / weak: assumptions are chosen which result in a high value of assets and/or a low value of liabilities
Cautious/ prudent/ conservative/ strong: assumptions are chosen which result in a low value of assets and/or a high value
of liabilities.

Reasons for calculating provisions and setting assumptions regarding purpose BAD MEDICS

 To value benefit improvements for a benefit scheme

 To determine liabilities to be shown in the provider’s published accounts and reports

Assumptions should reflect legislation and accounting principles. Matters to consider include:
- Using a going concern basis or break up basis
- Reflecting the true and fair value
- Whether best estimate or prudent

 To determine liabilities to be shown in internal management accounts and reports

Best estimate generally used

 To calculate discontinuance benefits / surrender benefits

Best estimate generally used, others might be adopted

 To value the provider for mergers and acquisitions

Best estimate might be used to achieve true and fair value for all parties. However, a different basis might be used
- Due to power imbalance between parties
- Because of a stronger desire to proceed by one party
- Need to hold margins to protect security

 To determine the excess of assets over liabilities, so that any discretionary benefits can be awarded
Prudent basis likely to err on the side of caution

 To provide disclosure information for beneficiaries

Assumptions reflect legislation. Realistic basis will typically be used with a range of results also provided

 To influence investment strategy

Realistic assumptions with sensitivity and scenario testing + stochastic approach can add value

 To set future contributions to a benefit scheme or premiums for insurance

Assumptions depends on
- Objectives of the parties concerned
- Structure of the membership

 To supervise solvency requirements

Need to consider degree of prudence
Prescribed legislation
Actuarial judgement
There may be a need to calculate global provisions to:
- Act as additional protection against insolvency
- Cover risks (financial and non-financial) that cannot necessarily be attributed to individual contracts
- Reflect degree of mismatching of assets and liabilities
Why is it necessary to have different mortality tables for different classes of life?

 A life table is assumed to reflect the mortality experience of a homogenous group of lives i.e. all lives to whom the
table applies will follow the same stochastic model for mortality.
 If it is constructed for a heterogeneous group, the mortality experience will depend on the exact mixture of lives
used to construct it, and it could be used to model mortality for another group only if it has the exact same mixture
of lives. This makes it very restrictive.
 Sometimes if only part of the mortality is heterogeneous, the table is separate for this duration and combined for the
rest of the duration (when it is homogeneous).
Principle factors contributing to variation in mortality and morbidity
Tables vary as per age, sex, social class, geographical areas and overtime. But real factors that cause differences are:
- occupation - nutrition -housing -climate change -education
-genetics -travel - religious attitude -marital status
Selection
1. Temporary initial selection:
Each group is defined by a specific event that affects all members at a particular age. Mortality patterns are seen to
differ only for the first few years (known as the select period) and the effects wear off over time. Can arise as a
result of underwriting process.
2. Class selection:
Source of heterogeneity is the permanent attributes of individuals – categorised on age/gender/occupation.
3. Time selection:
Mortality normally improves with calendar time – due to medical advances. (Exceptions: natural disaster/war)
4. Adverse selection / anti selection:
Characterised by the way in which select groups are formed rather than characteristics of the group. Involves an
element of self-selection that disrupts controlled selection process. E.g. lives with better health will opt for an
annuity pension instead of lump sum at retirement.
5. Spurious selection:
Ascribing differences to factors that are not the true causes e.g. a group classified by region might experience
difference in mortality due to different occupational mix/nutrition/standard of housing etc.
Expenses incurred by a product provider COST RAID
- Commission - Renewal administration
- Overheads - Asset management
- Sales and advertising - Initial administration
- Terminal e.g. paying benefits - Design of the contract

Types of expense
A. Fixed vs Variable expenses
Fixed expenses remain broadly fixed in real terms.
Variable expenses change directly according to level of business. Linked to no. of policies / premium / claim amount

Insurance companies:
Fixed – building maintenance
Variable – commission, postal costs for contracts, legal
Mix – salary of senior management would change if structure of business changed significantly

Benefit schemes:
Admin / legal / actuarial costs might be delegated to third parties that charge a fee. Inhouse services might be done
by sponsor’s employees so is charged to sponsor’s overheads.

B. Direct vs Indirect expenses

Direct expenses relate to a particular class of business such as underwriting costs, commissions etc.
 Indirect costs relate to supporting functions such as management, HR, computing etc.
Need for expense allocation
- To be loaded into premiums
- To calculate provisions
- To understand profitability of the product
- To analyse sources of surplus (deviations of actual from expected expenses)
- To analyse areas of inefficiency within the organization
- Financial planning (expense budgeting)
- Cashflow management (To ensure liquid funds are available)
Allocating expenses on the basis of class of business
Direct expenses

 If a department is dealing with just one class of business, expenses can be directly allocated to relevant class.
 If a department is dealing with multiple classes of business, timesheets can be kept to help split the costs between
classes
Indirect expenses
(i) Using a charging out basis – computer time and related staff resources could be charged to direct function
departments based on actual use.
(ii) Premises’ costs can be allocated by floor space taken up by department
(iii) For costs such as statutory fees, senior management costs, an arbitrary basis like adding expense at the end
of analysis as a percentage loading.

These loadings can be expressed as

- % of sum assured or premium
- % of funds under management
- Fixed amount per contract or a combination of these
- Fixed amount per claim or % of claim

Adjustments can then be made to reflect cross subsidies, inflation and competition
Allocating expenses on the basis of function
Function relates to timing of expenses. High level division includes
- Securing new business - Maintaining existing business - Terminating business
Then, depending on purpose of expense analyses, they might be further subdivided into
- Marketing - Sales and commissions - Processing and policy issue - Underwriting
Factors to consider when designing a contract AMPLE DIRECT FACTORS
1. Administration systems
The product can be administered on the company’s own systems or outsourced. It needs to be able to carry out the
function built into product design at the cost built into product price. Any changes need to be included in
development cost.

2. Market for the product

Products for the lower income group should be simple, clear insured event, affordable and transparent
Products for the higher income group can be flexible, higher costs, provision of options

3. Profitability
Factors like claims experience, expenses, inflation, investment returns, withdrawal rates, new business volumes etc.

4. Level and form of benefits

 Level is the amount and form refers to monetary/non-monetary, one off/regular etc. Depends on customer needs,
covered risks, ability to pay

5. Benefits offered on discontinuance / for an early leaver

 Life Insurance:
Which contracts- depending on market practice, regulation, likelihood, difficulty of assessing terms
Form of benefits- surrender / lapse / paid up
How to set terms- policy worth (reserves), PRE, competitions
Practical considerations- ease of calculation, frequency of change
 General insurance: Likely to be a lump sum reduced for charges
 Benefit schemes:
Form of benefits- For defined contribution scheme, it is based on member’s account on date of withdrawal. For
final salary defined benefit scheme, it is based on no. of years of service and salary at withdrawal increased at
some low rate.
How to set terms- benefits are known but if transferred, value will need to be equitable members who leave and
stay
Practical considerations- payment to member may be reduced to reflect a lower level of funding

6. Discretionary benefits
Life insurance – level of bonus
General insurance – scales for a no claims discount experience rating system
Benefit pension scheme- discretionary pension increases

7. Interests and needs of customers and other stakeholders ALPACAS

 Actuaries: Involved in initial costing, provisions, ongoing design process, modifications
 Lawyers: Drafting contract to support financial structure
 Providers of benefits: Influenced by market, available capital, expertise
 Accountants: Properly accounts for income and outgo
 Customers: Influenced by capacity to pay, risk appetite, benefit level, covered risks
 Administrators: Need to administer financial structures. Higher complexity, higher costs.
 Shareholders and financial backers: Will want regular reports of proper stewardship
 Sales and Marketing

8. Risk appetite

9. Expenses vs charges

10. Competitive pressure

Price: Products that cover basic needs where risk is well defined can be sold on price e.g. term
Product features: Offering unique terms might be a risk if the customer thinks they’re not getting comparative
returns. Or they may attract selective business and be a USP.

11. Timing of premiums / contributions

The more flexibility, the more complicated and expensive the product. However might enhance marketability and
competitiveness.

12. Financing
There could be loss in the first year (new business strain). For life insurance contracts the benefits are funded in
advance. But for benefit schemes, it might be pay as you go, in advance, regular payments building up etc.

13. Accounting implications

14. Consistency with other contracts

Major change will result in systems development which costs time and money.
Training of staff, printing new literature
 Might be unfair to existing customers

15. Terms and conditions of the contract

16. Options and guarantees

17. Regulation

18. Cross subsidies

How do you determine the cost of benefits? How do you calculate premium value?
The two main factors include frequency of occurrence and severity
Premium contributions can be calculated as value of benefits + value of expenses + contribution to profit
Other factors that can be taken into account are:
- Taxation - Commission (if not included in the expense)
- Cost of capital - Margins for contingencies
- Cost of options and guarantees - Basis for setting provisions incase it uses a different
- Reinsurance costs basis than for determining cost
- Use of experience rating to adjust future premiums - Investment income

Premiums also need to be tested for robustness. Profit testing models can be used to estimate results of providing
products under different scenarios. Market test premiums.
Price vs. Cost
The price of benefits can be more or less than the cost and is the value charged to the customer. It may differ because:
(i) The provider’s distribution system might allow him to sell above market price or take advantage of
economies of scale and reduce premiums charged.
(ii) The provider might have a captive market that is not price sensitive.
(iii) The provider might choose to sell a product that covers direct and variable cost but not fixed overheads in
order to stimulate sales. This is called loss-leading.
(iv) A cheap product can attract customers to other more profitable products of the company. They can take into
account the overall profit across the whole product range.
(v) Demand might exceed supply in a limited market, so higher premiums can be charged.
How do you determine the value of contributions for a benefit scheme?
Actual contribution rate = calculated contribution (cost of future benefits accruing) + variation
This variation arises from

 The scheme’s assets =/= to benefits already accrued resulting in a shortfall or surplus
 The sponsor may want to change the pace of funding by paying a higher or lower contribution in any year
- If the sponsoring company has performed badly it might have to cut contribution until recovery
- Opportunity cost of contributions and alternative investment opportunities
- Change in view of optimism / caution
A surplus in the benefit scheme would arise when:
- Assumptions about future experience were unduly pessimistic i.e. contributions were very high
- Assumptions were reasonable but experience was very favourable
- The sponsor paid more than recommended contributions
Types of funding
1. Pay as you go
2. Lump sum in advance (e.g. single premium)
3. Terminal funding (fund exists from the point at which a benefit starts to be paid)
4. Regular contribution (funds are gradually built up to a level sufficient to meet expected costs over the period between
the promise being made and the benefit first paid)
5. Just-in-time funding (same as terminal funding but triggered by an external event like bankruptcy)
6. Smoothed PAYG (funds set up to smooth costs under pay-as-you-go to allow for effects of timing differences
between contributions and benefits, population change, business cycles)
Factors affecting the choice of funding type ^ will depend on tax treatment and allocation of risk between the provider
of capital and receiver of benefit.
Process of risk management

Risk Risk
monitoring identificaiton

Risk Risk
financing classification

Risk Risk
control measurement

Risk identification Risk classification

- Recognition of risk - Categorize into groups
- Hardest aspect of risk management - Aids in calculation of cost of risk and value of
- Determine whether systematic / diversifiable diversification
- Preliminary identification of risk control process - Enables risk owner to be allocated
- Identify opportunities to exploit risk and gain
competitive advantage
- Determining risk appetite / tolerance level

Risk measurement Risk control

- Estimation of probability and severity of event - Determining and implementing methods of mitigation
occurring - Decide whether to mitigate or accept
- Carried out before and after risk control - Reduce probability of risk occurring
- Basis for evaluating and selecting methods of - Limit financial consequences of risk
control and whether risk should be accepted, - Limit severity of effects of risk
transferred, mitigated, shared. - Reduce consequences of risk that does occur
- Not all risks are a single point event
- Taking action when certain trigger points are reached
- Compare options to identify optimal choice

Risk financing Risk monitoring

- Determining the likely cost of each risk including - Regular view and reassessment of risk identified, new
cost of mitigation/ loss/ capital risks.
- Ensuring sufficient financial resources - Clear management responsibility for each risk
- Determine if risk appetite/ exposure has changed
- Report on occurred risks and how they were managed
- Assess effectiveness of current management process

Benefits of risk management SAC 2 GO

1. Improve stability and quality of business
2. Avoid surprises
3. Give confidence to stakeholders that business is well managed
4. Improve growth and returns by exploiting risk opportunities
5. Improve growth and returns through better management and allocating capital
6. Identify opportunities arising from risk arbitrage
7. Identify opportunities arising from natural synergies
Enterprise risk management
Risk might be managed at a group level rather than a business unit level for company units that
- Carry out same activity in different locations
- Carry out different activities in the same location
- Carry out different activities in different locations
- Operate in different countries
- Operate in different markets
- Be separate companies in a group with their own business units
Approaches to risk management at the enterprise level:
A. Parent company can determine overall risk appetite and divide this among business units.
Adv: Direct role of parent company in managing risk
Disadv:
- No benefits of diversification. (Crude method to allow for diversification is to rescale to 150% instead of 100%
of risk appetite)
- No pooling of risk.
- No economies of scale.
- Lack of capital efficiency

B. Establish group risk management function as a major activity at enterprise level. The group can then impose similar
risk assessment activities at the enterprise level. This enables results from various models to be combined at the
entity level. (holistic approach)
Adv:
- Allowance for pooling of risk
- diversification benefits
- economies of scale
- Capital efficiency
- Recognizing areas of systematic risk
- Enable the company to identify opportunities to enhance value
- Consistency across business units
Stakeholders in risk governance
- Directors / senior management

- Risk managers and any Chief Risk Officer

CRO’s role will be at the enterprise level. He is responsible for allocating risk budget to business units after
allowing for diversification and for monitoring the exposure to risk and documenting those that have
materialised and affected the group.
At the unit level, risk managers have to make full use of allocated budget as well as data collection, monitoring,
reporting.

- Employees
Employees should keep a look out for risks within the business and suggest ways in mitigating risk. They should
look at the risk governance framework and suggest changes. Reports from staff on risk should be noted and
rewarded through the normal appraisal system.

- Customers
Companies should encourage customer feedback systems and companies should carry out root-cause analysis
on customer complaints. Risks could be in products, website or when they visit company premises. Company
may need to encourage or reward such feedback.
 - Shareholders
Can drive risk governance by influencing development of the risk appetite statement and use their votes

- Credit rating agencies

Agencies can measure the risks associated with the company in various ways and use these in their ratings. This
may put pressure on the company to deal with unwanted risks.

- Regulators
May impose minimum standard of governance e.g. review risk process, impose sanctions, penalties, fair terms
and conditions etc. Needs to ensure company holds enough capital.

- Advisors
Their contribution depends on their role (e.g. customer facing / company facing). They should be encouraged
to note and report risks. Also to control/manage risks, where appropriate. These can be risks associated with
e.g. the company’s products, website or visiting premises.
Techniques for risk identification
(a) Use experience of staff that has joined from similar organizations and of broad industry consultants

(b) Risk checklists

For risk based capital regimes such as for Solvency II, the standard formula for calculating capital requirements
covers many risks. List might not be exhaustive. E.g. it does not include equity volatility risk.

(c) Risks in project management

 High level preliminary analysis of risk to determine if it is worth analysing further
 Brainstorming session of experts and senior management to think long term strategy with the aim to
o Identify project risks with their upsides and downsides
o Discuss risks and their interdependency
o Place a broad initial evaluation on each risk considering frequency and probability
o Generate initial mitigation options
o Discuss options briefly
 Desktop analysis by identifying further risks and mitigation options via research
 Opinions of experts and plans for financing
 Set out all risks in a risk register or matrix with cross references to other risks where there is interdependency

(d) Risk classification

Allocate risks into categories in order to aid other stages of risk management control cycle

 Market risk: Risk related to changes in investment market values or interest and inflation rate
Asset value changes can occur from
Changes in market value of equity and property (systematic or specific to particular markets)
Changes in interest rate or inflation (mainly affect fixed interest and index linked securities)
Liability value changes can occur if
Benefits provided to policyholders/members are related to investment market values or interest rates
Level of provisions might be affected by change in interest rates
Asset liability mismatch might arise due to
Range of assets available might not be wide enough to match long duration liabilities
Liabilities might be uncertain in amount and timing
Presence of options resulting in uncertain cashflows
May include discretionary benefits to be paid
High cost of maintaining a fully matched portfolio
Consequences of mismatching include greater exposure to market risk, reinvestment risk, liquidity risk

 Credit risk: Risk of failure of third parties to meet obligations

- Issuer of corporate bond defaulting on capital or interest payment
 - Changes to credit quality of variations in credit spread
- Counterparty risk
- General debtors

 Liquidity risk: Risk that an individual or company, although solvent, does have sufficient available financial
resources to enable it to meet obligations as they fall due.

 Business risk: Risks specific to business undertaken e.g. underwriting risk, insurance risk, financing risk,
exposure risk, competition risk

 Operational risk:
o Risk of loss resulting from inadequate or failed internal processes, people and systems
o Risk from an external event
o Dominance of a single individual over running of a business
o Reliance on third parties
Features of a company that can influence its risk appetite
1. Existing exposure to particular risks 2. Culture of the company
3. Size 4. Period of time for which it has operated
5. Level of capital available 6. Existence of a parent company/ other guarantors
7. Level of regulatory control 8. Institutional structure (mutual / proprietary)
9. Previous experience of board members 10. Attitude of individual risk owners/ providers of capital

Principles of insurable risk

1. Insurable interest in the risk being insured
2. Financially and reasonably quantifiable
3. Claim amount should bear relationship to financial loss incurred
4. Risk events must be independent of each other
5. Probability of occurrence should be small
6. Large number of similar risks should be pooled to reduce variance
7. There should be an ultimate limit on liability undertaken by insurer
8. Moral hazards should be eliminated
9. There should be sufficient statistical data to enable estimation of extent and probability of risk
Compare regulatory and economic capital requirements

Regulatory capital requirements Economic capital requirements

Relate to? The amount of capital that needs to be held in order to meet future obligations
Internal model Can be used for both calculations
Method The regulator may prescribe The company will make its own decisions on assumptions
assumptions and methodology and methodology
Determined by Using factor based capital charges Likely to be modelled
or a simple formula
Holding Additional solvency capital needed Held in excess of market consistent value of liabilities
requirements in excess of provisions on
regulatory valuation basis /
additional capital + prudential
margin on liability valuation basis
Strength of Maybe higher as the regulator’s Maybe lower due to sophisticated allowance for
requirements aim is to protect policyholders diversification benefits
However it might be higher because the company:
- holds capital for future strategic objectives not included in
the regulator’s time horizon
- is risk averse
- uses a stricter risk measure (TVaR)
- uses a standard formula / model to determine regulatory
capital but is riskier than average risk reflected
- targeting a higher credit rating
Describe how an insurance company could assess its economic capital situation including consideration of type
of model that could be used.
An assessment of an insurance company’s economic capital position requires the company to look at its economic capital
requirement and availability.

Economic capital requirement

It is the amount of capital that the company determines is appropriate to hold given its assets, its liabilities, and its
business objectives.
Typically it will be determined based upon:
The risk profile of the individual assets and liabilities in its portfolio
The correlation of the risk
The level of overall credit deterioration that the company wishes to be able to withstand.

For each major risk type (e.g. credit, market, operational), a stochastic model or a deterministic model with scenario or
stress testing will generally be used to determine the capital requirement. A suitable stochastic model needs to produce
internally-consistent possible future scenarios, e.g. for market risk reflecting downturns in investment performance and
inflation and their impacts on levels of withdrawals and new business. An advantage of such a stochastic model is that
it can automatically allow for correlations between different risk scenarios.

The company would project its balance sheet for each of a large number of future scenarios, which are intended to
represent all the risks the company faces.

A risk measure, e.g. VaR or TVaR, would be used to determine the economic capital requirement, e.g. sufficient capital
to maintain solvency in ten years’ time in 99.5% of scenarios.

Economic capital available

The starting point for assessing the economic capital available is for the company to draw up an economic balance sheet,
which shows the market value of the company’s assets and the market value of its liabilities.

The market value of liabilities can be determined using a discounted cashflow approach. From this, the economic capital
available would be determined as the excess of the market value of the assets over the market value of the liabilities.

For tradable assets, the market value of assets should be easily available.
It is possible that the portfolio may include some assets which are not tradable or for which a market value is not instantly
available, and so an alternative valuation approach is needed. In the unlikely event that any of its liabilities are tradable,
the insurance company could look up the market value of these liabilities. However, for the majority of its liabilities it
is likely to have to use an alternative approach, e.g. use the market value of a portfolio of assets whose cashflows
replicate the liability cashflows in all circumstances, if such a replicating portfolio is available.

Alternatively, the company could determine the expected value of the unpaid liabilities stated on a present value best
estimate basis and add a risk margin.

In addition to its current available economic capital, the company may also look at the availability in the market and the
likely cost of various sources of further capital.

Discuss the use of the standard formula to calculate SCR under Solvency II

Under Solvency II standard formula, SCR is determined based on a combination of stress tests, scenarios and factor
based capital charges.

These allow for underwriting, market, credit default, and operational risk. E.g. a factor-based capital charge for the risk
associated with a worsening of mortality experience for an assurance provider might be of the form: (factor * sum at
risk) or a withdrawal risk stress test may be to hold sufficient capital to be able to withstand either a 50% increase or
50% decrease in withdrawal rates.

The final SCR is determined from these individual component parts, using a correlation matrix to make allowance for
any diversification benefits.

Advantages:
- SCR calculation is less complex, time-consuming and resource-intensive to perform.
 - Particularly attractive for smaller insurance companies
- Avoids considerable work required in developing an internal model that meets the regulators’ requirements
- The cost of doing this work may be greater than any benefit that would be achieved via a lower SCR.
- Even if the company is developing an internal model for other purposes there would be additional costs and
uncertainty in seeking regulatory approval for its use in Solvency II.

Disadvantages:
- As the calibration of the standard formula is based on an ‘average’ company the approximations it makes are
not necessarily appropriate to all companies.
- A company with a risk profile very different from the ‘average’ underlying the model may have a lower SCR if
it calculated it using an internal model that reflected its own business.
- Companies with sophisticated risk management systems and controls may also benefit from a lower SCR
calculated by an internal model that reflects these items more fully.
- The company may be developing an internal model in any event, e.g. to assess its economic capital position.
Using the internal model for Solvency II would not therefore require the cost of developing a model ‘from
scratch’ and would reduce inconsistencies.

Why would an insurance company use an internal model to calculate SCR under Solvency II?

The main reason that the company will want to apply for an internal model is to reduce the capital requirement of the
company. Likely to be a feasible undertaking only for large companies.

Advantages:
- Ability to write more business due to increased capital
- Pursuing a less restrictive investment strategy due to reduced capital requirements
- The internal model will reflect the company’s specific risk or business characteristics rather than the standard
model which may have inappropriate assumptions embedded into the calculations based on an average
company.
- The standard formula may not include risk classes that are important to the insurance company, which an
internal model can take account of.
- The company may have assumptions built of more appropriate experience which can help assess both the
assumptions and the relative stresses for its capital model. An internal model could take this approach into
account.
- It could also remove any approximations that a standard formula approach may have taken into account.
- The company could already be using the internal model for other metrics (e.g. Economic Capital) and could be
therefore more efficient to only run one model
- The company may have spent a lot of time and money in building the model which it therefore wants to exploit
(e.g. use to reduce the capital requirement).

Why would a company opt for a standard model instead of an internal model?

 The standard model would not require detailed work to be done on building the specific model required.
 There will also be considerable time and effort involved on the part the insurance company in reviewing and seeking
approval for an internal model. There will also be costs involved.
 The company may not have enough data or experience to build its own model.
 The company may use the prescribed model for its other business.
 The prescribed model may fit well with the specific product and so could be appropriate.
 The insurance company would need to make sure that any model will be resilient over time, which will be easier
with a standard model than with an internal model. Essentially the regulator would assist.
 A standard model may help address any concerns that the public may have with the company. This could lead to
increased confidence in the new product
 May allow the insurance company to obtain regulatory approval quicker from the regulator as they will not need to
review and approve the internal model along with understanding any specific risks. This would enable the insurance
company to launch the product more quickly into the market.

Economic Capital requirements may be lower than its solvency capital requirements

The Solvency Capital Requirement (SCR) – this is the target level of capital below which companies may need to discuss
remedies with their regulators
Economic capital is the amount of capital that a provider determines is appropriate to hold given its assets, its liabilities,
and its business objectives.
 The regulator will probably require a company to hold more capital than they would consider necessary.
 It will probably ensure that the capital assumptions are stronger than the insurance company would otherwise
assume
 Therefore the liabilities and capital will be higher under solvency basis than the economic basis.
 Therefore the surplus (assets less liabilities less capital requirements) will be higher under the economic basis
 The regulator will make assumptions relating to the average risk about companies when considering suitable
requirements for solvency capital.
 The mortality (or other) assumptions may not be appropriate to the experience and expertise of the company
 Also, the regulator will be unlikely to allow for the benefits of diversification between the annuity business and
the term assurance business (i.e. mortality offsetting)
 Assets used may not be the same if there are differences in regulation on certain asset classes, i.e. inadmissible
assets

Profit, surplus and surplus arising

Profit = revenue – expenditure

Surplus = value of assets – value of liabilities
Surplus arising = change in surplus over a given time period
(Profit = surplus arising)

Reasons for performing an analysis of surplus or profit

To assist the management in decision making:

1. To show the financial effect of divergences between valuation assumptions and actual experience
2. To determine assumptions that are the most financially significant
E.g. actual investment return over the year might be very different than expected but impact over the year might
only be marginal
3. To show the financial effect of writing new business
E.g. if a prudent basis is used, new business will contribute negatively to surplus at year end
4. To identify non-recurring components of surplus thus enabling appropriate decisions to be made about
distribution.
5. To provide management information
6. To give information on trends in the experience of the provider to feed back into the ACC

To provide information for other purposes:

7. To provide data for use in executive remuneration schemes
8. To provide detailed information for publication to accounts

For data and calculation checks:

9. To validate assumptions and calculations used
10. To provide check on valuation data and process if carried out independently
11. To reconcile values for successive years
12. To demonstrate that variance in financial effect of individual sources completely describes overall variance

Carrying out an analysis of surplus includes

 Projecting expected results

It will be necessary to determine expected values in the form of hypothetical accounts based on future values of
economic, market and other assumptions when the business was written. These can then be compared to actual
performance of business. Items such as revenue account and balance sheet are usually projected

 Modelling considerations
- Use base from models used when products were developed
- Results from initial product pricing model can be combined to build a complete model of provider’s future
revenue accounts
- Ensure elements in the account are self-consistent. Premiums, investment income, death claims etc. should not
be projected independently
- Multiple profit test results by expected number of contracts to be sold in each future year (scaling)
 - Then, for each future year, number of contracts still in force from previous years will need to be added in.
- With progress of time, a second model can be built from original profit test but using actual business volumes.
Comparison of the two models will identify whether the difference arises due to difference in experience or sale
volumes.

 Comparison of different models

Three models compared will be
Expected experience with expected volumes of business
Expected experience with actual volumes of business
Actual experience with actual volumes of business
The actual revenue accounts can be compared to projections and helps answer questions such as
- Has the provider earned more in investment returns than expected
- Has the provider spent more in design of product than expected
- Have termination rates followed expectations
The answers will give an indication whether profitability criteria are being met in practice.

 Comparison of expenses
This includes taking into account actual volume of business sold or average volume of business in force.
Additional business (above expected) brings in additional margins and can justify additional expense.
So, it is unit cost (expense per policy) rather than monetary expenditure (total expense) that becomes the key metric.

Factors affecting surplus

- Mortality - Morbidity - Claim frequency

- Claim amount - Withdrawal / lapses - Investment income + gains
- Expense - Commission - Salary growth
- Inflation - Taxation - Premiums/ contributions
- New business levels - Failure of reinsurer - Failure of derivative counterparty
- Restructuring of business / funds - Change in valuation methods - Change in valuation assumptions
- Competition - Claims underwriting - Change in legislation

Levers on surplus / how can providers control and manage cost of business?

I. Reduce likelihood of claims through:

- Good underwriting of new business (minimise anti-selection):
o Requesting data such as previous claim history, convictions, defaults etc.
o Unacceptably high risks should be defined and excluded
o Policy documentation is watertight
o Data of fraudulent claims are shared with other insurers
- Good underwriting at claims stage (loss adjusting) – depends on size of claim / perceived risk of fraud
E.g. requirement to see death certificate, medical certificate, extent of damage, reports by loss assessors, pictures
of stolen goods, evidence of business continuity incidents etc.
- Customer incentives e.g. no claims discount

II. Reduce cost of claims through:

- Cost effective claims management procedures e.g. reviewing ongoing claims
For a product that provides income benefit on incapacity, the beneficiary should provide ongoing proof of
eligibility. The provider might also provide rehab services to assist recovery.
- Using reinsurance (limits volatility, protects against risk of large claims)
- Reducing future benefit payments e.g. raising age at which pension payments kick in
- Minimising guarantees e.g. not guaranteeing regular benefit increases but only discretionary ones
- Use of excess e.g. the policyholder pays the first half of the claim and the insurer pays the remaining

III. Controlling expenses:

- Reviewing expenses to standardise procedures for efficiency
- Keeping flexible charges and premiums
- Ensuring expenses are commensurate with claim size
E.g. a chronic condition can justify higher costs and more time in assessment than acute illness of limited
duration
IV. Increasing renewals / reducing lapses
o Issue of renewal notices
o Automatic renewals unless the policyholder specifies not to
o Loyalty discounts and additions
o Good customer service and claims handling
o Marketing activities for brand promotion
o Maintenance of competitive premiums
o Monitoring aggressive inappropriate mis-selling
o Monitoring competitive pricing

V. Increasing investment returns

By choosing investments that are appropriate to nature, term, currency and uncertainty of liabilities and risk
appetite of the provider, maximising return.

VI. Effective tax management

o Tax allowances being utilised fully
o Tax being paid on time to avoid penalties
o Tax efficient investment vehicles being used

Issues surrounding the amount of surplus to distribute

Life insurance companies:

 Provision of capital  Margins for future adverse experience
 Business objectives of the company  Stakeholder expectations

Benefit schemes:
 Legislation  Scheme rules
 Tax treatment  Manager discretion
 Risk exposure to various parties  Source of surplus
 Expected effect on industrial relations

Reasons for monitoring

1. To update methods and assumptions so that they reflect future experience more closely
2. To monitor trends in experience to take corrective actions
3. To provide information to management and other key stakeholders
4. To understand sources/relative significance of divergence

Data required for monitoring + analysis

 There must be a reasonable volume of stable, consistent data. The data used for each group should be
o In a similar form
o Extracted from the same source
o Grouped according to the same criteria
o Equal in terms of reliability

 The data needs to be divided into sufficiently homogenous groups according to the relevant risk factors.
This ideal must be balanced against the danger of creating data cells that have too little data in them to be credible
The level of detail will depend on volume of data available. It will indicate:
o Whether or not analysis will produce meaningful results
o Extent to which data can be subdivided without leading to similar problems

 It is necessary to have data on exposure to risk divided into the same cell structure as experience data. An analysis
would not be valid unless they are matched – “principle of correspondence”

 Statistical factors include mortality rates, morbidity rates and withdrawal rates.
Analysis will include calculation for each age band, the number of deaths/withdrawals divided by the exposed to
risk of death/withdrawal. Results can then be compared to assumptions or relevant standard tables.

 Economic factors usually have the biggest impact on results but are generally outside management control.
 o Interest rates/ investment returns: compare actual vs assumed
o Expense inflation: actual level would be determined by removing costs that were included only in previous
or current data from expense analysis and considering change in unit cost.
o Salary growth: making separate assumptions for general inflation and individual promotional increases

 Take into account changes that have occurred that reduces effectiveness of past data. Attempt to separate effects of
trends, cycles, random variation. Account for gradual change in experience from period to period.

Factors to be taken into account in translating results of experience investigation into assumptions

a) Purpose for which assumptions will be used

b) Significance of a particular assumption to overall results
c) Relationship or consistency between assumptions
d) Needs of the client
e) Margins in assumptions vs risk discount rate
f) Legislative or regulatory constraints
g) Time horizons
h) Credibility of results and hence need for margins

Benefit risks for pension schemes

Defined Benefit Scheme Defined Contribution Scheme

 Inadequate funds due to  Poorer than expected annuity purchase terms
o Underfunding (if annuity is purchased)
o Sponsor insolvency
o Asset / liability mismatch
 Illiquid assets  Lower than expected investment returns
 Benefit changes e.g. by the State  Higher than expected expense charges
 Member’s needs not being met due to:  Member’s needs not being met due to:
o Misunderstanding o Design
o Inflation erosion of value o Inflation erosion of value
o Changed circumstances
For both
 Sponsor default  Failure by sponsor to pay contributions on time
 Takeover of the sponsor  Decision by sponsor to reduce benefits
 Inadequate communication with beneficiaries  General economic mismanagement by sponsor

Contribution risks

Defined Benefit Scheme Defined Contribution Scheme

 Future contributions unknown and depend on:  Contributions might be linked to an inflationary
o Amount of benefit factor
o Eligibility to accrue benefits
o Eligibility to receive benefits  If not linked to inflation, resultant benefits might not
o Inflation be adequate in real terms
o Investment returns net of tax and expenses
 Extra contributions might be required to meet a  Unaffordable contributions
shortfall resulting in liquidity risk or excessive
contributions
 Takeover by third party not willing to continue  Insufficient liquidity to make payments in a timely
contributions manner
For both, extra contributions might be required due to:
 Loss of funds due to fraud/misappropriation  Incorrect benefit payments
 Decisions by parties to whom power has been  Administrative costs e.g. to comply with changes in
delegated legislation
 Inappropriate advice  Fines / removal of tax status due to noncompliance
 Changes to tax rates / tax status
Inappropriate advice might result from:
- Incompetence / insufficient experience of the advisor
- Lack of integrity of the advisor perhaps due to sales related payments
- Use of unsuitable model or parameters
- Errors in the data relating to the beneficiaries
- State encouraged but appropriate actions
- Over-complicated products

Why the contribution rate for a defined benefit scheme may increase over time

 increasing longevity
 poor investment returns
 default of some investments
 salary growth higher than expected, increasing the liabilities for active members
 expenses higher than expected
 more stringent regulation
 removal / reduction of tax incentives relating to employer contributions or investments for pension schemes
 option costs greater than expected
 contributions to any central discontinuance fund being higher than expected
 increased number of deaths in service or fall in deaths in service, dependent upon whether deaths are a source
of deficit / surplus for the scheme
 pension increases greater than expected, e.g. if price inflation linked increases provided
 fewer transfers out of the scheme than expected (assuming transfers out are a source of surplus)
 more ill-health retirements than expected (if ill-health retirement benefits are more generous than normal
retirement benefits)
 benefit improvements (which may be required by regulation)
 increasing maturity of the membership

Factors that determine degree of prudence in assumptions required in valuing defined benefit pension scheme

 Purpose for the valuation e.g. a degree of prudence is likely to be included in a valuation to assess the scheme’s
funding position, to ensure the security of benefits.
 The objectives of the client e.g. the sponsor may not want too many margins for prudence to be included, whereas
if the client is the trustees then they would prefer a cushion for prudence.
 However, the trustees will not want to choose a basis that is so prudent it could encourage the sponsor to close the
scheme, threaten the sponsor’s solvency and active members’ job security.
 For some valuations the assumptions may be prescribed, for example by regulation or accounting standards
 Alternatively, some of the assumptions may be prescribed or there may be a minimum level of prudence that is
acceptable.
 The characteristics of the scheme, e.g.:
o size of the scheme (a larger scheme is likely to be more stable, and therefore may use a less prudent basis)
o scheme’s funding level, i.e. the excess of assets over liabilities
o maturity of the scheme
o the risk profile of the assets held
o degree of certainty there is about likely future experience
 The attitude of the sponsor to risk
 ability to make good any shortfall in the future if a less cautious approach is adopted
 The approach adopted by similar schemes may be considered.
 The degree of certainty about any one particular assumption that is being set will also be considered. For example
if future mortality experience can be predicted with a high degree of certainty then the margin in the mortality
assumption may be small.
 Margins may need to be higher where there is a lack of data.
 When introducing margins for prudence into individual assumptions, the actuary needs to consider the implications
for the basis as a whole. There is a risk that small margins introduced in many assumptions could lead to a basis
that is unintentionally too prudent.
 Past practice should be considered, as there may be a need to be consistent with previous valuations.
 There may be also be tax implications e.g. a more prudent basis would defer the sponsor’s profit, and therefore defer
its tax liabilities.
 The trustees should consider the financial significance of the assumptions
 Assumptions for the discount rate, price inflation and life expectancy are likely to be critically important, and care
should be taken that the level of prudence is appropriate.
 Other assumptions, such as family statistics, are likely to be less important for most schemes, and so it may be
acceptable to use a best estimate assumption for these assumptions, and include margins elsewhere.

Overall security

Investment risk
- Uncertainty over level and incidence of investment income
- Uncertainty over level and incidence of capital gain
- Reinvestment risk arising from mismatch of assets and liabilities.
- Default risk
- Investment returns being lower than expected
- Benefits not being appreciated due to poor investment returns
- Liquidity risk
- Lack of diversification
- Changes in the taxation of investment income and gains
- Investment expenses

Model, parameter and data risk

Risk resulting from errors in determining contribution or premium rates as a result of
- The use of an unsuitable model
- The use of unsuitable parameters
- Errors in any data used to determine parameters for the models
- Errors in the data relating to the beneficiaries

Business risks for financial product providers

1. Mortality / longevity risk

Change in long term mortality rate, mortality improvement rate change, one off event, random variation
2. Morbidity risk
Change in rate of incidence of illness, duration, one off pandemic shock
3. General insurance claim risks (claim variation/ underwriting/ exposure risk)
Change in climate, natural events, customer behaviour, increase in inflation
4. Expense risk
Budget over-runs, poor estimation, lack of control, one off exceptional cost, inflation, mismatched timing of
cashflows, inadequate spread of expense
5. Persistency / renewal risk
6. Volume and mix of business risk
7. Option and guarantees risk
8. Reinsurance risk

Methods of valuing individual investments

Market Smoothed Fair Discounted Stochastic Arbitrage Historic Written up and written
value market value value cashflow models value book value down book value

A. Market value
 Quoted securities generally have a bid price, offer price and mid-market value
 Advantages:
o Objective
o Easily obtained
o Starting point for asset valuation
 Disadvantages:
o Can only be known with certainty at the date a transaction takes place
o Volatility: maybe subject to wide fluctuations in the short term, varies constantly
o More than one figure may be quoted at any time
o Difficult to value liabilities consistently unless they are very closely matched
o Difficult to obtain for unquoted investments like direct property and venture capital holdings
B. Smoothed market value
 Where market value is available, they can be smoothed by taking some form of average over a specified period.
 It becomes a view as to whether asset is cheap or expensive relative to smoothed market value
 Advantage: removes daily fluctuations
 Disadvantage: inconsistent liability valuations because appropriate discount rate is indeterminate and requires
judgement.

C. Fair value
 Developed by IASB, it is a market based method used for financial reporting.
 For most assets, it is the market price
 For those where market price isn’t available,
o Seek an indicative price from broker
o Use most recent known price adjusted in line with movement in appropriate index
o Stochastic modelling
D. Discounted cashflow
 PV of expected future cashflows using long term assumptions. Used to value equity and property.
 Advantage: Easily made consistent with basis used to value liabilities.
 Disadvantage: Relies on assessment of suitable discount rate which is less straightforward other than for high quality
fixed interest stocks.

E. Stochastic models
 Extension of discounted cashflows where future cashflows, interest rates, or both are treated as random variables
 Advantages:
1. appropriate for complex cases like presence of embedded options / derivatives
2. gives a distribution of results so better picture of a valuation
3. consistency with liability valuation
 Disadvantages:
4. Maybe too complex for many applications
5. Results dependent on assumed distributions which maybe highly subjective

F. Arbitrage value
 Calculated by replicating the investment with a combination of other investments and applying the condition that in
efficient markets, the values must be equal.
 Advantage: used to value derivatives
 Disadvantage: impossible to apply in other markets as it is difficult to replicate many assets

G. Historic book value

 Price originally paid for the asset
 Often used for fixed assets in published accounts
 Advantages:
o Objective
o Conservative
o Easy to understand and obtain
 Disadvantage: Little merit since it is historical

H. Written up or written down book value

 Historic book value adjusted periodically for movements in value
 May still not equal market value
Market values
Advantages:
1. Objective
2. Realistic as realisable value on sale (assuming the bid price is used)
3. Easy as doesn’t require calculation
 4. Well understood and accepted
5. Can be used as a comparison to other valuation methods to see whether an asset seems over- or under-
priced

Disadvantages:
6. may not be readily obtainable (e.g. unquoted instruments)
7. volatile – values may fluctuate greatly even in the short term
8. may not reflect value of future proceeds
9. a decision is required about whether bid, mid or offer prices should be used
10. difficult to ensure consistency of basis with that of the liability valuation
11. value reflects the position of the marginal investor rather than the individual (e.g. taxation)
12. may not be the realisable value on sale (e.g. if dealing in large volumes or illiquid stocks)
Valuing specific investments
1. Bond valuation: discounted cashflow technique using rates consistent with market rate spot yield curve

2. Equity valuation:
a. Market value
Usually serves as the starting point of valuation if there is a suitable market

b. Dividend discount model

To value unlisted shares / check whether the MV is reasonable/over-/under-priced
Discounted value of estimated future dividend stream

General model:
V = ∑∞
𝑡=1 𝐷𝑡 𝑣(𝑡)
V = value of share / Dt = gross amount of tth dividend payment / v(t) = discount factor

Simplified model assumptions:

 Dividends are payable annually
 Dividends grow at a constant rate, g, per annum
 The required rate of return, i, is independent of the time at which payments are received
 i>g
 i and g are defined consistently – e.g. both include inflation or are net of inflation
 Dividend proceeds can be reinvested at i pa
 No tax and expenses.
 Shares are held forever

𝐷 𝐷 (1+𝑔) 𝐷 (1+𝑔)2
V = (1+𝑖) + (1+𝑖)2
+ (1+𝑖)3 + … where D is the dividend to be paid one year from now
𝐷 (1+𝑔)1 (1+𝑔)2
V= (1+𝑖)
(1 + (1+𝑖) 1 + (1+𝑖)2
+⋯ )
𝐷 1
V= x
(1+𝑖) 1− (1+𝑔)
(1+𝑖)
1
V=Dx (1+𝑖)−(1+𝑔)
𝐷
V = 𝑖−𝑔
𝐷0 (1+𝑔)
V= 𝑖−𝑔
where D0 is the dividend just paid

Issues to consider when applying the simplified model:

 We do not know the value of i
 The assumption of constant rate of i might not be appropriate if yield curve is steeply sloping
 We do not know the value of g
 Constant dividend growth might not be realistic
 Results obtained are very sensitive to (i-g)
 Taxes are ignored.
 Expenses are ignored
  Assumption is of annual dividend payments even though they might be half yearly
 Model is useless unless i > g

c. Net asset value (NAV): adopted for companies with significant tangible assets. Can be used to value
investment trusts as market price of each shareholding / number of shares in issue – expenses

d. Value added measures:

Shareholder value is intrinsic or underlying value of an investment
Economic value added (EVA) looks at one year’s results and deducts cost of capital. If it is positive,
activities have created value. Is an indication of success - acts as a bridge between quoted share value
and accounting value to give framework for executive compensation scheme.

e. Others – factor based calculations for companies that are not making profit and NAV is not appropriate

3. Property valuation:
a. Indications from similar recent transactions with adjustments
b. Discounted cashflow
i. Rents are payable in perpetuity
ii. Rents are quoted net of expenses and tax
iii. Rents are net of costs of modernising or refurbishing
(12) (12) (12)
V = 𝑅0 𝑎̈ 𝑛1 ⌉ + 𝑅1 𝑎̈ 𝑛2 −𝑛1 ⌉ 𝑣 𝑛1 + 𝑅2 𝑎̈ 𝑛3 −𝑛2 ⌉ 𝑣 𝑛2 + ⋯ @ i %

R0= initial rent/ R1 R2 = rent at times 1, 2 / nx = timing of rent reviews / i = discount rate
The discount rate could be based on yield on a bond of suitable term adjusted for risk and lack of marketability

4. Options, futures, swaps valuation

Techniques based on no arbitrage – value taken is the cost of closing out the contract by buying an equal and
opposite option/future/swap on current terms.

Swaps can also be values by discounting two component cashflows. It can be seen as a series of bonds.
PV of investor’s income – PV of investor’s outgo = 0 at inception
We ignore market maker’s profit and expense. We also ignore tax and risk, and assume both parties have the
same view of future interest rates. As market rate changes, cashflow values will alter to reflect positive net value
for one party and negative net value for the other.

Advantages and disadvantages of valuing assets and liabilities using an interest rate representing long term
expected return on assets

+ The interest rate used for discounting will be stable, so yielding stable valuation results.
+ Easier to ensure that the discount rates used to value assets and liabilities are consistent.
+ Removes the difficulties involved with determining suitable market-based discount rates.
– The discount rate used is entirely subjective.
– A single discount rate is unrealistic, as investment returns will vary over time.
– It may be difficult to explain or justify to other parties, e.g. trustees or directors.

Evaluation of risk

1. Scenario analysis
 Deterministic method
 Useful when it is difficult to fit full probability distributions to risk events because risks are not suitable for
modelling or that it would need so many subjective parameters that the value of using it would erode.
 Used to evaluate operational risk but can also be used to assess impact of financial risk like global recession
 Steps
o Risk exposures need to be grouped into categories e.g. financial fraud, risk of system error etc
o For each group, develop a plausible adverse scenario. This scenario would be representative of all the
risks in the group
o For each scenario, scenario must be translated into assumptions for various risk factors in the model.
 o Consequences of the risk event occurring are calculated. Financial consequences include redress paid,
cost of correcting systems, regulatory fees, opportunity cost etc.
o Total cost calculated are taken as financial cost of all risks represented by chosen scenario
 Drawback: quantifies severity of scenario but not probability of it occurring

2. Stress testing
 Deterministic method
 Used where risk events are extreme. Commonly used to model extreme market movements but also have
applications in modelling credit and liquidity risk
 E.g. subjecting an asset portfolio to extreme market movements by radically changing underlying assumptions.
This helps gain insight into sensitivities and risk factors. Asset correlations and volatility is observed to increase
 Two types of stress test:
o To identify weak areas and investigate effects of localised stress by looking at the effect of different
combination of correlations and volatilities
o To gauge impact of market turmoil affecting all parameters while ensuring consistency between
correlation when they are stressed

3. Reverse stress testing

 Construction of a severe stress scenario
 Identify a scenario which would be just enough to stop the company fulfilling strategic business plan
 Business plans need to consider both short term and long term plans.
 Extreme event can occur internally due to insufficient funds or externally

4. Stochastic modelling
 Extension of stress test
 All variables that give rise to risk incorporated as probability distributions with dynamic correlations specified
 The model can determine the capital required to just avoid ruin at a desired level of probability
 It is extremely complex to specify and build
 The resultant run time is impractical with even modern computing power
 Necessary to limit ideal scope by one of the following approached
o Restrict duration of model to two years if risk criterion is expressed as one year ruin probability. Some
parts of the model (valuation) will require projections to run-off.
o Limit the no. of risk variables that are modelled stochastically. Deterministic approach can be used for
others. Variables having an adverse effect when they move in only one direction can be modelled
deterministically with scenario analysis
o Carry out a number of runs with different single stochastic variable followed by a single deterministic
run using all worst case scenarios together. This will determine effect of interactions

Methods of aggregating risk

i. Stochastic modelling (complete give complete distribution of outcomes to calculate capital at a predetermined
level of probability)

ii. Numerical aggregation of risk (practical simplification)

 Fully dependent risk events - sum of capital required for each risk at a given probability level
Simple and quick to apply, no assumptions needed
Will overstate capital requirements if risks are partially dependent resulting in inefficient use of
capital, opportunity cost, increased CoC
𝑛

∑ 𝑅𝑗
𝑗=1

 Fully independent risk events – Capital required for combination < sum of individual capital
𝑛

√∑ 𝑅𝑗2
𝑗=1
  Partially dependent risk events - Capital required for combination < sum of individual capital
The extent of difference is called diversification benefit. Maximised if correlations are negative

iii. Correlation matrices

Simple approach to aggregate risks that are partially dependent
Common technique that is well understood
It is a collection of correlation factors each of represent strength of dependency between risks
Matrix will be n x n in size and symmetrical
Relay on underlying assumptions which may not hold in practice (e.g. correlation factors do not vary under
different conditions)
Population of matrix will need subjective assessment
𝑛,𝑛

√ ∑ 𝐶𝑖𝑗 𝑅𝑖 𝑅𝑗
𝑖=1,𝑗=1

iv. Copulas
An organization might know approximately individual probability distributions for each risk (marginal
distributions)
Joint distribution combines information from marginal distributions with other information on the way in which
the risks interact with each other
A copula is a function that takes marginal cumulative distribution as input and gives joint cumulative
distribution as output
It provides a way of calculation joint probabilities of risk (e.g. probability of return on equity and bond portfolio
both falling below a certain level)
Different copulas are used to describe different degrees of dependence between random variables including
dependence in the tail of distributions
Widely used in quantitative finance to model tail risk which helps optimise portfolio of investments as capital
requirements tend to be assessed in relation to events that would fall in the tail of distribution e.g. 1 in 200 year
event
Requires expertise as can be complex mathematically
Choice of copula and calibration or parameterisation can be difficult
Not easy to explain to end users

Value at Risk (VaR)

 Meaning: It is a function that generalises likelihood of underperforming by providing a statistical measure of

downside risk. It measures the maximum potential loss on a portfolio over a given future period with a given
confidence degree
 Example: a 99% one day VaR is the maximum loss on a portfolio over a one day period with 99% confidence.
 It can be measured as an absolute term or relative to a benchmark
 It is calculated assuming a normal distribution of results. If the distribution is fat tailed or skewed, tracking error
may be misleading. Portfolios exposed to credit risk, systematic bias or derivatives might be non-normal. The
usefulness of VaR would depend on modelling in terms of statistical distributions or Monte Carlo simulations. Lack
of sufficient data observations in the tails means there is increasing subjectivity
 It does quantify the size of the tail. We can use Tail VaR to show the expected shortfall below a certain level given
that the shortfall has occurred.
 The risk measure can be expressed as the expected shortfall below a certain level.
𝐿
Expected Shortfall = E [Max (L − X, 0)] = ∫−∞(𝐿 − 𝑥)𝑓(𝑥)𝑑𝑥 where L is the chosen benchmark level.
If L is chosen to be a particular percentile point on the distribution, then the risk measure is known as the Tail VaR.

Importance of risk reporting

Management: PIC MICE

i. Price, reserve and determine capital requirements
ii. Identify new risks faced by the business
iii. Control systems are put in place to manage risks
iv. Monitor and manage effectiveness of risk and control systems
v. Interaction between individual risks is understood
vi. Changing risks over time are assessed
vii. Ensure better understanding of risks faced in terms of quantifying materiality and financial impact

Shareholders:
Give greater understanding of attractiveness of business for investment

Credit rating agencies:

Help determine appropriate credit rating for business

Regulator:
Give regulator greater understanding of areas of business which require more scrutiny

Choice of method of risk control

When faced with a risk each stakeholder can choose whether to:
 Avoid the risk altogether
 Reduce the risk, i.e. by either reducing the probability of occurrence or the consequences or both
 Reject the need for financial coverage of that risk because it is either trivial or largely diversified
 Retain all the risk
 Transfer all the risk – for example by paying a premium to another party to transfer all the risk to that party
 Transfer part of the risk

Each option for mitigating a risk can be evaluated by assessing:

 The likely effect on frequency, consequence and expected value
 Any feasibility and cost of implementing the option
 Any ‘secondary risks’ resulting from the option
 Further mitigating actions to respond to secondary risks
 The overall impact of each option on the distribution of net present values (NPVs).

The extent to which a stakeholder will choose to pass on all or some of the risk will depend on several factors:
 How likely the stakeholder believes the risk event is to happen
 The stakeholder’s risk appetite
 The resources that the stakeholder has to finance the cost of the risk event should it happen
 The amount required by another party to take on the risk
 The willingness of another party to take on the risk

Benefits of reinsurance

Reinsurance is a way of reducing, or removing, some of the risks.

The main benefits of reinsurance to an insurance company are:
 a reduction in claims volatility and hence:
– Smoother profits
– Reduced capital requirements
– An increased capacity to write more business and achieve diversification
 the limitation of large losses arising from:
– A single claim on a single risk
– A single event
– Cumulative events
– Geographical and portfolio concentrations of risk
and hence:
– a reduced risk of insolvency
– increased capacity to write larger risks
 access to the expertise of the reinsurer

Types of reinsurance

Reinsurance may be arranged on a case by case basis – facultative or defined series of risks maybe covered - treaty
 I. Proportional – Reinsurer covers an agreed proportion of each risk. Have to be administered automatically
therefore require a treaty
a. Quota share: Reinsurance is a fixed percentage of each and every risk insured R%
Advantages: Disadvantages:
- Diversification - Same proportion is ceded irrespective of size
- Write larger portfolio of risks - Same proportion is ceded irrespective of volatility
- Encourage reciprocal business - Does not cap cost of large claims
- Simplicity of administration

b. Surplus: Specifies retention level and a maximum level of cover available. The proportion is ten used
in the same way as quote share.
Advantages: Disadvantages:
- Allows provider to accept risk that would be - More complex administration
otherwise too big
- Diversification - Does not cap cost of large claims
- Flexible in terms of risk proportions
- Helps to achieve well balanced risk portfolio

II. Non Proportional

Excess off loss: Cost to ceding company of large claim is capped with liability above a certain limit being passed
to a reinsurer. If claim exceeds upper limit of reinsurer, remaining will revert back to ceding company.

Advantages: Disadvantages:
- Caps losses allowing the cedant to take on risks that - Provider will pay a premium which might be
could produce very large claims greater than expected recoveries as must
include loadings for expense and profit
- Protects cedant against individual or aggregate large - XL premiums may be greater than pure risk
claims premium for cover.
- Helps stabilise year to year profit
- Efficient use of capital by reducing variance of claims

Types of reinsurance

Non
Proportional
proportional

Excess of loss Catastrophe

Quota share Surplus Risk XL Aggregate XL
(XL) XL

Alternative risk covers (ART)

1. Integrated risk cover: Reinsurance agreements that cover several lines of GI business for several years. They
might include cover for financial risks
Advantages: Disadvantages:
- Avoid buying excessive cover - Credit risk in relation to cover provider
- Smooth results - Lack of availability
- Lock in attractive terms - Higher expenses due to personalized contracts
- Substitute for debt, equity - Difficulty in structuring risk management in a
holistic, multi-line way
2. Securitisation
3. Post loss funding
4. Insurance derivatives
5. Swaps
- Reinsurance - Longevity - Weather
Reasons for using ART

 Provision of cover that might otherwise be unavailable

 Stabilisation of results
 Cheaper cover
 Tax advantage
 Greater security of payment
 Management of solvency margins
 More effective provision of risk management
 As a source of capital

What can be used to aid management and control of risk for a financial product provider?

 Diversification
 Underwriting at the proposal stage
 Claims control procedure
 Management control systems

Diversification
Risk can be diversified within:
o Lines of business
Company can market a wide range of contracts insuring a wide range of risks
This would be expensive in terms of admin systems, staff training etc.
It would also make the company generalist with little scope for niche business
To avoid this, companies can use reciprocal quota share reinsurance. One company reinsures part of its
business with another in exchange for accepting part of its reinsurer’s business. Each company then
concentrates its sale, advertising, marketing on its chosen segment. Thus spreading exposure which
reduces claims volatility.

o Geographical areas of business

o Providers of reinsurance
o Investments – asset classes
o Investments – assets held within a class

Underwriting at the proposal stage

As a risk management tool:

1. Anti-selection protection: It involves the proposer not disclosing certain information to the insurer that would
enable the insurer to better price the risk – because the insurer did not ask for it. It enables a provider to decline
really severe risks.
2. Enable homogeneous classification: A single premium can be charged for homogeneous groups. Adequate
classification within the underwriting process will help to ensure that all risks are fairly rated.
3. Identify risks for which special terms need to be quoted: Accepting a large proportion of business at standard
rates will enables easier administration and easier to present to customers. Particularly in GI, insurers might
simply decline risks that do not fit into its rating matrix
4. For substandard risks, identify most suitable approach and level for special terms:
 Increasing premiums
 Decreasing benefits
 Exclusion clauses
 Deferring cover until further information is known
 Declining cover
5. Ensures claims experience does not depart too far from assumed.
6. For larger proposals, financial underwriting helps reduce risk from over-insurance. It will alert the insurer to
attempted anti-selection.

Life insurance underwriting includes:

o Medical evidence
Asking questions on the proposal form
Obtaining reports from policyholder accounts
Medical examination
 Performing specialist tests

o Lifestyle underwriting
Risks associated with occupation / leisure pursuits / country of residence

o Financial underwriting
To counter risks of over insurance
Financial health is assessed e.g. level of income

Claims control system

It mitigates the consequences of a financial risk by guarding against fraudulent or excessive claims.

Life insurance
o Reviewing death certificate
o Details declared in the proposal form were correct
o More important for sickness contracts where it is continuous and basis is more subjective

The cost of implementing and maintaining a controls system must be compared to benefits gained, for example:
- Most general insurers will accept small claims and a single estimate for necessary repairs
- Above the monetary limit, they might wish to see 2 – 3 estimates
- At a further level, they might require that the damage be inspected
- For larger claims, they might appoint a firm of loss adjusters

Management control systems

I. Data recording
a. Company should hold good quality data on all the risks
b. Particular emphasis on risk factors identified when product was designed
c. It can assist in ensuring adequate provisions are established
d. Reduce operational risks from having poor data
II. Accounting and auditing
a. Good provisions to be established
b. Regular premiums to be collected
c. Reassure providers of finance
III. Monitoring liabilities
a. Important to protect against aggregation of risks of a specific type to an unacceptable level
b. For new business strain, quantify the amount of new business – impose a max limit on amount of NB
volumes accepted
c. Premium rating might involve cross subsidies – monitor business mix
d. Monitor across business areas i.e. at enterprise level
IV. Options and guarantees
Determine if they are likely to bite

a. Liability hedging
Choosing assets which match liabilities for consistent movement by using derivatives
b. Dynamic hedging
Rebalancing underlying portfolio as and when market conditions change
c. Restriction of eligibility criteria
Only allowing options to be exercises on a limited no. of dates.

V. Due Diligence

Issues with underwriting data available for a renewal versus a new policy

 For a new policy, company will get information for all current underwriting factors used for determining premiums
 information received will be up to date
 the insurer has greater freedom
o to refuse to quote
o reject cover
o apply special conditions to cover
 For renewals insurance company will only have information previously collected to use in the underwriting
 From a conduct perspective there is reduced freedom to refuse to quote / reject cover/ apply special conditions
 company may not have information for all factors used for new business
 The longer the period since the policy was originally taken out the more missing information on current underwriting
factors
 Differences in underwriting factors for new and existing business provides anti-selection opportunity i.e. a
policyholder can test if a new quote provides a higher or lower premium before renewing
 The potential for anti-selection increases with the period since the policy was originally taken out
 The potential for under-insurance increases
 Sum assureds may be indexed to reduce this risk
 Claims underwriting likely to include greater discretion/materiality if underwriting information is out of date rather
than refuse claim.
 This is in particular if the contract automatically renews.
 A key issue is how aware policyholder is that the information is out of date.
 The number of policies, say 10 years since originally underwritten will be lower than recent business so has lower
credibility
 The underwriting data on older policies will be more out of date so less credible
 Renewals can be quicker and cheaper as already hold some verified data
 They have other data over life of policy such as claims or telematics
 New rating factors can be applied on renewals

When can applicant dishonesty in answering proposal form questions be a risk to the insurer?

 Depends on the sales method used. It is easier to give misleading answers about height, weight on direct
marketing forms for posting vs if a salesperson is involved.
 Depends on the degree of underwriting as strict underwriting acts as a deterrent and less likelihood of fraud
 Dishonesty is not a major problem if premiums charged allow for it correctly. This will happen if premiums are
based on the company’s mortality experience for its own policyholders and they displayed the same degree of
dishonesty in answering their original proposal form
So dishonesty will only be a problem if
 it is increasing
 premiums are based on another group of lives
 underwriting process was stricter for these lives
Dishonesty will be less of a problem if
 it can be picked up at claims control stage
 products where mortality / morbidity risk is only small

Methods for valuation of liabilities

 Traditional discounted cashflows method

 Market based / Fair value approach

o One approach to estimating fair values is to consider the liabilities as a series of financial options, and to
use option pricing techniques to assess a value.
o Another approach to obtaining a fair value of liabilities is to use a ‘replicating portfolio’.
o A further approach values liabilities using an asset-based discount rate.

Fair value methods for valuing liabilities

I. Replicating portfolio method

a. Mark to market / Market value method
o Assets are taken at market value.
o Liabilities are discounted at the yields on investments that match the liabilities – often bonds.
This may be government or corporate bonds, the latter allowing for credit risk
o A better, but more complicated, approach would be to use term-standard discount rates that
vary over time to reflect the shape of the yield curve.
o The market rate of inflation is derived as the difference between the yields on suitable portfolios
of fixed-interest and index-linked bonds.

b. Bond yields plus risk premium

 o Assets are taken at market value
o Liabilities are valued using a discount rate that is found by adjusting (usually increasing) bond
yields by the addition of either a constant or a variable equity risk premium.
o Where a constant equity risk premium is used, the result is the same as for the mark to market
method (i.e. valuing an asset to reflect its current market levels) except that value of the
liabilities is (usually) lower as they are now discounted at a higher rate.
o It is more common to use a variable risk premium, which is derived by a combination of market
information and actuarial judgement.

II. Asset-based discount rate

o Assets are taken at market value.
o An implied market discount rate is determined for each asset class, e.g. for fixed-interest securities it
may be the gross redemption yield, for equities it involves estimating the discount rate implied by the
current market price and the expected dividend and/or sale proceeds.
o The liabilities are valued using a discount rate calculated as the weighted average of the individual
discount rates based on the proportions invested in each asset class.
o The discount rate could also be determined using the distribution of the actual investment portfolio or
the scheme’s strategic benchmark

III. Valuing options

It is not always appropriate to assume that the highest cost option is always exercised. For example, the attraction
of cash or a tax-free benefit might mean that individuals do not exercise an option that is in the money from the
provider’s perspective.
The risk of anti-selection must be allowed for when valuing options.
Options in liabilities can be valued by finding a market option that replicates it. A closed form approximation
may be used, e.g. Black-Scholes.
Contract values are highly sensitive to option pricing methods and assumptions.
The assumptions used when valuing an option will depend on, among other things:
o The state of the economy, and hence must be scenario specific
o Demographic factors such as age, health and employment status
o Cultural bias
o Consumer sophistication.

IV. Valuing guarantees

Guarantees are usually best valued by a stochastic approach, taking the class of business as a whole. A stochastic
model allows for the likelihood of the guarantee biting and its expected cost.
They may become more or less onerous on the provider over time depending on how experience develops.
The value of guarantees and their influences on consumer behaviour will vary widely according to the economic
scenarios and the sophistication of the market.

Method Asset valuation Liability valuation

Traditional Discounted cashflows using Discount rate is same long-term rate as used for assets
discounted cashflow long-term rate based on actual
holding or notional portfolio
Replicating portfolio Market value Discount rate implied by market price of investments that
(mark to market) match liabilities – often bonds
Replicating portfolio Market value Discount rate as in mark to market method, but then
(bond yields plus risk adjusted to take account of higher expected returns on other
premium) asset classes
Asset-based discount Market value Discount rate is the expected return on assets, weighted by
rate proportions held of each asset class
Fair (or market) value Market value Discounting using risk-free rates.

Sensitivity analysis can be used:

To help determine the extent of the margins needed in assumptions, to allow for adverse future experience
In determining the extent of any global provisions required.
Sensitivity analysis can be done on single or multiple assumptions.
Methods for allowing for risk in cashflows

I. Allowance for risk in a traditional discounted cashflow valuation

a. Best estimate and margin

A risk margin is built in to each assumption by using ‘best estimate’ assumptions together with an
explicit margin for caution.

b. Contingency loading
This approach is to increase the liability value by a certain percentage.

c. Discounting cashflows at a risk premium

This is the traditional discounted cashflow approach where the cashflows are assessed on a best estimate
basis, and then discounted at a rate of return that reflects the overall risk of the project or liability.

II. Allowance for risk in a market consistent or fair valuation

a. Financial risk
Allowed for by a replicating portfolio or through stochastic modelling and the use of a suitably
calibrated asset model.

b. Non-financial risk
Allowed for by adjusting the expected future cashflows or by an adjustment to the rate used to discount
cashflows. Alternatively, an extra provision or a capital requirement, such as the risk margin under
Solvency II, can be held for non-financial risks. These adjustments will depend on:
The amount of the risk
The cost of the risk implied by market risk preferences.

Methods for calculating provisions

1. Statistical analysis: If the population exposed to a risk is large enough, and the consequence of a risk event is
approximately normally distributed
2. Case-by-case estimates: If the insured risks are rare events and also have a large variability in outcome.
3. Proportionate approach: For risks which a provider has accepted but where the risk event has not yet occurred
- set a provision on the basis that the premium charged is a fair assessment of the cost of the risk, expenses, and
profit.
4. Equalisation reserves: where a product provider might wish to exhibit stable results from year to year, but where
the portfolio contains low probability risks with a large and highly volatile financial outcome. To smooth results,
a company may establish a claims equalisation reserve in years when no claim arises, with a view to using the
reserve to smooth results when a claim does occur.
They might not be accepted by regulators as
Equalisation reserves are not provisions as they do not cover a future liability.
They could be seen as a way of deferring profits e.g. a ploy for reducing the tax being paid in a particular year.

Requirements that any project should meet in order to ensure successful project management

1. Clear definition of aim of the project

2. Full planning
3. Risk analysis
4. Monitoring of development
5. Measurement of performance and quality standards
6. Thorough testing at all stages
7. Care in managing different strands of the project (critical path analysis)
8. Move along at an appropriate pace
9. Stable but challenging relationships with suppliers
10. Positive conflict management
11. Excellent communication
12. A supportive environment
13. Schedule for considerations for each milestone review point
14. Strong experienced leaders
Steps a general insurance company may require policyholder to follow to process claims

 Reporting the claims with personal private details.

o Insurance co. will set procedures in motion e.g. assign staff admin records, reconcile with proposals etc.
o Establish identity and obtain other evidence
 Receive report, information from appropriate investigating authority e.g. police or fire service.
o Authorities will verify extent of damage, truth of claim
o Might help determine cause of claim event
o Might determine neighbouring liabilities which have arisen for which insurer holds responsibility
o Any exclusion to cause might come into effect e.g. gas left on causing fire
 Initial description of claim to insurance company.
o Understand type of claim and decide level of underwriting needed
o It will help assign specialists, and level of detail and costs involved
o May help to understand credibility
o May enable a provisional reserve to be set up if the claim is huge
o It may be possible to disqualify the claim or at least strongly imply it, straight away, e.g. a clear exclusion.
 Complete claim form including items claimed for and amount claimed.
o Company needs to know exactly how much is being claimed and what items make up the claim.
o The claim form will collate all the necessary information in one place.
o Make administration a lot easier.
o The claimant will be required to sign a statement confirming that the information provided is truthful. This
will allow the insurance company the opportunity to reduce or disqualify the claim if false statements are
made
 Explain any immediate needs (e.g. emergency accommodation)
o Obtaining details of the claim also allows the eventual claim amount to be managed e.g. check family claims
for adequate alternative temporary accommodation but not luxurious compared with old house.
 Obtain evidence of costs incurred or to be incurred, e.g. repairs, rebuilding with estimates/receipts.
o they will require independent quotes i.e. more than 1, for any large jobs needed, e.g. rebuilding
o Independent valuations will be needed to determine the true loss.
o Special attention will be paid to valuable contents claimed, for e.g. electrical goods, furniture, valuables etc.
 Co-operate with insurer's claim process and required timescales.
o reduced complaints/compensation payouts
o avoids interest payments on claims
o reduces bad publicity
 Allow insurer (e.g. loss assessor) access, information to investigate claim
o As well as relying on third parties, the insurance company will want to send in its own experts to assess
losses and gain a fuller picture. This can only really be done by access to the site.
o Will encourage the family to be more accurate with their claim amount. Obstruction may be seen as a reason
to more closely examine the claim.
o Give vital corroboration (or otherwise), i.e. are claim amounts reasonable, causes covered etc.
 Decide whether or not to accept initial offer from the insurance company.
o They will need to explain their reasoning and why the offer may be less than the amount claimed for
(especially if all or part of the claim is disqualified).
 Negotiate or take legal advice/action to improve terms of the offer.
o there may be scope to re-assess the offer
o In order to avoid paying too much, the onus will be on the family to provide adequate justification.
o There may be regulatory or industry bodies to whom the family could appeal, e.g. arbitration or an
ombudsman.
o The family may take legal action and threaten to sue the insurance company, e.g. for breach of contract.
o The insurance company will weigh up the costs of contesting a claim against the possible award made.
Hence a compromise sum may be offered.

Reasons why an individual may purchase life insurance that is not the most appropriate for their needs

o Might not be aware of what products are available

o Lack of understanding of own needs
o Not anticipating likely change from current needs
o Lack of financial awareness/ education means they can’t match products to needs
o See high returns but ignore risks
o Based on distributors – can be more convincing than stall brochures
o Likelihood of independent intermediaries pushing for products with higher commissions
o A competitor’s product might be more suitable but intermediate wants to grab business
o Distributor may not have the knowledge required to identify the most appropriate product
o Misleading sales information
o Suitable product might not be available
o Suitable product might not be affordable
o Suitable product might be available only grouped with other products, not individually
o Legal requirement to take a certain policy, e.g. fund must be used to purchase an annuity.

Reasons why a government might want to increase level of personal savings

 There may be short term economic concerns. If savings are too low, spending is likely to be higher. This may lead
to too-high economic growth and/or inflation in the short term.
 Generally thought that low levels of savings would result in an unbalanced/unstable economy, too reliant on
spending. The government may wish to avoid the negative consequences of such an economy:
• Too much build-up of personal debt
• Possible current account deficit (imports>exports)
• Unstable economic growth
 Longer term there may be a wish to stimulate investment in the economy. Ultimately personal savings form the
foundation of Institutional or business investments. Built up savings can therefore, in turn, be invested.
 A greater range of government projects e.g. infrastructure can then be undertaken. Investment in turn should lead to
economic growth. (Circular flow of income effect.) Increasingly important for investment to be made e.g. in new
technology/automations, or to deal with shifting trends e.g. ageing population.
 Institutional investment may simply be increased into government bonds, avoiding bond yields having to rise so
much. High levels of personal savings help keep real interest rates low, and this in turn can further stimulate
investment. Similarly, businesses may be able to invest more so as to increase productivity.
 If people save for themselves, the government may be able to cut back on spending, particularly in the medium to
longer term. For example, government social security/housing/medical/long term care/pension benefits may be
reduced.
 There may be purely paternalistic reasons e.g. better society if people have at least some level of savings for
emergencies.
 The economy may be heading for lower growth or recession. The government wants people to get prepared for
leaner times ahead by saving more now.
 There may be tax reasons e.g. want to raise more taxes from savings.
 The government may have made election promises/targets to increase personal savings.