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Subject SA3 (General Insurance Specialist Applications) — September 2006 — Examiners’ Report

Page 8

• So likely to give significant weight to market loss ratio on both accidentyears.

The strongest candidates understood that both the accident years would bemore immature than a typical accident year because no policies were writtenin the first half of the first underwriting year. A number of candidates talked

at length about the validity of benchmarks but did not appreciate that therewas little alternative but to rely on them.

2 (i) Advantages:• When an accident involving a total loss of the vehicle occurs, road risk

insurance companies will usually pay out the actual value of the vehicle.• This will usually be considerably less than the original purchase price of

the vehicle due to market value depreciation within the UK motor salesmarket.

• Depreciation of the vehicle market value will be particularly steep in thefirst three years of a vehicle’s life before slowing down thereafter.

• Vehicle purchasers will have financial peace of mind in the knowledgethat they will be covered in the event of accidents where they were not to blame or driving at the time (e.g. theft of the vehicle) or involved completeor irreparable damage to the vehicle (e.g. fire, total write-off of vehicle in aroad accident).

• Road risk car insurers will not take into consideration any outstanding loanon the vehicle purchase.

• Holding gap insurance cover will assist the policyholder in paying off anyoutstanding amount of the loan rather than be in a position of negativeequity.

• The policy will pay out in full if the vehicle is written off by an untraceddriver or failure to pay by the owner’s insurance cover for another reason.

• If the cover is free then this is good for the purchaser, but the cost mayalready be included in the cost of the vehicle.

• Premiums are known in advance in terms of level and period of paymentso will assist in financial planning (or could be regarded as an additionalmonthly element to budget for in addition to road risk premium and loanrepayment).

• No need to argue with the motor insurer on the value of the car.

Disadvantages:• The rates charged for gap insurance are often high.• The cover may be of limited use to a car purchaser who changes his car

frequently, e.g. once a year.• Value depends on risk appetite of car purchaser: he may not wish to payfor something considered unlikely.

• No benefit is provided if there is a bad accident but the car is not writtenoff.

• The customer may not want to pay three years cover in the first year.• There is no value in the first year if the motor insurer gives “new for old”

cover in the first year

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Page 10

• The volume of business could be much higher or lower than expected.• Too little business might not cover the expenses incurred in writing a new

line of business.• So part of the agreement might be early cessation of the contract if

volumes do not exceed a certain amount to cut losses early.• Higher could entail more risk than desired.• Mitigate by imposing a pre-determined limit in the contract with the motor

manufacturer.• Economic conditions impacting on market values of vehicles and therefore

severity of claims for gap insurance are leveraged. For example, a 5%increase in depreciation value has a greater than 5% increase in claimseverity.

• Impacts on business plan of a downturn in volumes of business andimplications on expenses versus premium income to meet these?

• Potential failure of vehicle manufacturer and impacts on market valuesresulting from this.

• Mitigate by modelling potential scenarios within Business Plan allowing

for variation in volumes of business written.• In the event of a total loss, the insured has no incentive to dispute theamount paid by his private car insurer as will receive same amount in totalwhatever amount paid: could mean higher than expected payout from gapinsurance.

• Could mitigate by clause in contract enabling gap insurer to negotiateamounts payable by communication and agreement with private carinsurer.

• Could be moral hazard from underinsurance on car policy (even notcomprehensive).

• Mitigate by clause in gap policy stating that car insurance policy should becomprehensive and car fully insured.

The best answers to this question were those that focused on the particularrisks of gap insurance. Many candidates did not appreciate the geared impacton claim severity of higher than expected depreciation and therefore did notgive enough attention to risk factors impacting market value of the vehicles.

(iii)• Claims and exposure data are required for both the frequency and severity

elements.• No historic data exist for this scheme as it is new.• Internal motor data could be used to determine possible claims experience

on this scheme.• Total loss claims frequency for each of the first three years of ownershipof a vehicle could be derived from the company’s motor experience ifthere is a reasonable history.

• This should be split down between theft, total fire/damage and flood ifdata allows and is credible.

• Use existing policy data to determine frequencies by rating cell (e.g. byage/gender of customer, location, security features).

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Page 11

• Consider trends in write off experience e.g. as a result of anti-speedinginitiatives or increased security.

• Claims severity data: need to separate out property damage part of claims.• Claims severity data: allow for excesses on motor policy.• Severity will be modelled using purchase price and the market value of

each type of vehicle.• Purchase prices could be obtained from the manufacturer for each vehicle

type.• This data will need to be projected forward according to purchase price

inflation expected in future.• Market value by vehicle type likely to be available from Claims

department who will have information on expected settlement costs fortotal losses.

• Alternatively, industry data may be available (e.g. GLASS) providinginformation on trade-in prices of second hand vehicles in the motor marketas these will be similar to the payout on total loss claims by the road riskinsurer.

• Residual value decay information can also be obtained from publishedinformation on the subject.• Inflation assumptions required for claims settlement costs of total losses.

Look at existing data to determine any trends with vehicle price inflation.• Check to see if there have been any historic changes in motor claims

handling procedures.• Obtain expected sales by vehicle from the manufacturer…• ...and likely customer profiles.• Claims handling costs may also be included in the risk premium.• Allowance should be made for reduced exposure due to resale of cars

within three years, if cover ceases on resale.• Allowance may also be made for the probability that not all premiums are

received (e.g. if a total loss occurs or car is resold or policyholder dies andthe premium payments stop). Or other monthly payment adjustments.

• Information on resale volumes should be available from company’s own orindustry data e.g. from DVLA.

Some candidates discussed data required for calculating the office premium(e.g. fixed expenses, loading for profit) which gained no credit as this questionwas specifically on the risk premium. A number of candidates listed a lot ofdetailed data items, e.g. those used for a standard motor insurance policy, thatwould not realistically be used in this situation. The stronger candidates weremore commercial in their answers, and more realistic about data that would

be publicly available. The weaker candidates talked about using the data from other insurers, which showed a lack of commerciality.

(iv) Other data when considering whether to underwrite:• Likely changes in economic factors that may influence car sales (e.g. price

inflation, wageroll inflation, unemployment levels).• How long has the motor manufacturer been trading?• Existing relationship with manufacturer.• Opportunity for cross-sell.

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Faculty of Actuaries Institute of Actuaries

EXAMINATION

18 April 2007 (am)

Subject SA3 — General InsuranceSpecialist Applications

Time allowed: Three hours

INSTRUCTIONS TO THE CANDIDATE

1. Enter all the candidate and examination details as requested on the front of your answerbooklet.

2. You have 15 minutes at the start of the examination in which to read the questions.

You are strongly encouraged to use this time for reading only, but notes may be made.You then have three hours to complete the paper.

3. You must not start writing your answers in the booklet until instructed to do so by thesupervisor.

4. Mark allocations are shown in brackets.

5. Attempt both questions, beginning your answer to each question on a separate sheet.

6. Candidates should show calculations where this is appropriate.

AT THE END OF THE EXAMINATION

Hand in BOTH your answer booklet, with any additional sheets firmly attached, and thisquestion paper.

In addition to this paper you should have available the 2002 edition of theFormulae and Tables and your own electronic calculator.

Faculty of ActuariesSA3 A2007 © Institute of Actuaries

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SA3 A2007—2

1 You are the reserving actuary at a small UK general insurance company writing just private household buildings and contents insurance. Having joined last year, youhave just completed your first review of the latest year-end figures. Your companyuses an annual basis of accounting and the latest financial year ended on 31 March2007. You have been asked by the Board to provide your best estimate of theanticipated loss ratio for the year-end accounts and explain the level of uncertaintyinherent in your estimate.

You are also aware of the following information/facts:

Financial year ending 31 March2000 2001 2002 2003 2004 2005 2006 2007

estimateGross WrittenPremium (£m) 66.51 70.50 74.73 79.21 83.96 89.00 94.34 100.00

Booked AccidentYear Loss Ratio n/a 98% 102% 105% 120% 94% 95%

Note: For many years Gross Written Premium has been increasing at 6% per annum.

• The policy cover was changed significantly on 1 October 2003 as follows, withyour predecessor’s estimate of the associated expected impact on incurred claimsin a typical year on an additive basis shown in brackets:

− Excess for subsidence claims increased from £500 to £2,500 (15% reduction).

− New exclusion of subsidence due to defective design / workmanship in thefirst ten years (15% reduction).

− Minor additions to cover (5% increase).

• The various analyses you have undertaken lead you to believe that the underlyingtrend in incurred claims (after allowing for prior year adjustments) has been risingat an average rate of about 10% per annum, assuming no changes in cover.

• A heat wave was recorded in August 2003, along with rainfall well belowaverage.

• July 2006 was the hottest month on record, along with rainfall well belowaverage.

Ignoring the effects of any reinsurance:

(i) List the different types of reserves that you might include in your estimate of provisions. [3]

(ii) Discuss the advantages and disadvantages of reserving on an underwritingyear basis. [4]

(iii) Define the term loss ratio, giving examples. [3]

(iv) Calculate the expected accident year loss ratio for the 2007 financial year,detailing any assumptions you make. [18]

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SA3 A2007—3 PLEASE TURN OVER

(v) Discuss:

(a) the extent to which any assumptions you have made may not be valid

(b) any potential areas of uncertainty associated with the assumptions in(a), and

(c) how you might seek to improve the reliability of the estimates youmake by adjusting the assumptions in (a).

[10][Total 38]

2 Megasure Group was established in Japan over 100 years ago. Its headquarters arestill in Japan and it has become one of the world’s largest general insurance andreinsurance organisations. Although it does not write any business in Europe at

present, it has operations in many other countries worldwide. Megasure Group writesmost types of insurance and reinsurance business, although not every product is

written in every country.

Following a strategic review, Megasure Group is considering writing generalinsurance business in Europe. You are a consulting actuary and have been engaged toadvise Megasure Group. You have been told that:

• It has initially decided to write only commercial property business. Howeverinsurance will only be provided on large commercial risks, including large office

blocks or factories.

• Both insurance and reinsurance business will be written.

• The business will be written in London.

Megasure Group is considering two methods of entering the European market:

A Becoming a corporate name on a Lloyd’s syndicate writing commercial property business.

B Establishing a wholly owned subsidiary company in the London market towrite this business.

Initially they would like advice to help them choose between the two market entryoptions above.

(i) Define the following terms:

(a) Lloyd’s(b) The London Market

[2]

(ii) Describe the main features of Lloyd’s. [8]

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SA3 A2007—4

(iii) Describe the main differences between becoming a corporate name on aLloyd’s syndicate and establishing a wholly owned subsidiary. For eachdifference, explain why it may be important for Megasure Group in decidingits preferred method of entering the market. [12]

Megasure Group subsequently decides to establish a wholly owned subsidiary,Megasure Insurance Company Europe (MICE). You have been approached to assistMICE in estimating its capital requirements for regulatory purposes. MICE will startunderwriting in 2008. You have produced the following estimates for the first threeyears of operations, based on MICE’s business plan:

TABLE 1 Estimated Capital Requirements for MICE Amounts in £ millionsYear 2008 2009 2010

MCR 10 20 35 RMM 10 20 35 ECR 25 35 45 ICA 35 45 50

(iv) State the meaning of each of the abbreviations MCR, RMM, ECR and ICAand give a brief description. Details of how these amounts are calculated arenot required. [4]

Megasure has considered the amounts shown in Table 1. Megasure needs to transfercapital to MICE in 2007 in order that MICE can obtain approval from the FSA to startwriting business in 2008.

(v) Describe the factors that Megasure should consider when deciding on theinitial capitalisation of MICE. Your answer should consider each of MCR,ECR and ICA, in addition to any other relevant factors. [13]

In its business plan, MICE assumed it would purchase excess of loss reinsurance andthat the net cost of this reinsurance would be £1 million per year. You allowed forthis reinsurance when estimating the ICA amounts shown in Table 1. MICE has nowasked you to produce an ICA estimate assuming that no reinsurance is purchased.Your revised estimates are shown below, together with the original estimates fromTable 1.

TABLE 2 Alternative ICA Estimates for MICE Amounts in £ millions Year 2008 2009 2010

ICA – if reinsurance is purchased 35 45 50 ICA – if no reinsurance is purchased 40 50 55

(vi) MICE is considering whether it should buy reinsurance or not. Discuss thematters that MICE and its parent, Megasure, should consider. [8]

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SA3 A2007—5

MICE is preparing to submit its authorisation application to the FSA. An FSAofficial is quoted in the press as saying that London Market insurers must monitortheir pricing more closely. MICE has called you to discuss this matter.

(vii) List ways in which MICE can make sure it charges adequate premiums,commenting on the practicality of each suggestion. [9]

Following authorisation from the FSA, MICE is considering writing another line of business in addition to commercial property.

(viii) Discuss the issues that MICE should consider before it decides whether or notto write an additional line of insurance. [6]

[Total 62]

END OF PAPER

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EXAMINATION

April 2007

Subject SA3 — General Insurance

Specialist Applications

EXAMINERS’ REPORT

Introduction

The attached subject report has been written by the Principal Examiner with the aim ofhelping candidates. The questions and comments are based around Core Reading as theinterpretation of the syllabus to which the examiners are working. They have however givencredit for any alternative approach or interpretation which they consider to be reasonable.

M A StockerChairman of the Board of Examiners

June 2007

Comments

Individual comments are shown after each part-question.

© Faculty of Actuaries© Institute of Actuaries

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Subject SA3 (General Insurance Specialist Applications) — April 2007 — Examiners’ Report

Page 2

1 (i) Outstanding reported claims reserveIBNRIBNERClaims handling reserveReopened claims reserveCatastrophe reserveEqualisation reserveUnearned Premium ReserveAdditional Unexpired Risk Reserve

Comments on question 1(i): Bookwork generally well answered by most candidates.

(ii) Advantages:

Avoids heterogeneity arising due to:

• mix of policy coverage (including terms and conditions)• mix of underwriting basis / use of rating factors• changes in the mix of business

Easier to allocate to underwriting year if date of loss is unclear.

IBNR is automatically included in any reserve estimate.

URR is automatically included in any reserve estimate.

Disadvantages:

Takes longer for each year to become fully runoff, giving rise to greater potential uncertainty within the estimates.

Does not match the accounting procedures used by the company.

Can mask any potential changes in IBNR patterns.

Combines periods of potentially different claims environments.

May spread the incidence of a catastrophe or major claim event, potentiallyreducing the apparent magnitude of the event.

Comments on question 1(ii): Bookwork with most candidates making a reasonable attempt

(iii) Loss ratio: otherwise known as Claim ratio.

It is the ratio of the cost of claims to the corresponding premiums.

Claim ratios may relate to periods other than a year.

e.g. Incurred claims / earned premium for a given accounting year

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Page 3

Or estimated ultimate claims / earned premium for a given accountingyear.Or incurred claims / written premium for a given underwriting year.Estimated ultimate claims / estimated ultimate premium for a givenunderwriting year.

Incurred claims and earned premiums for a given accounting year shouldinclude estimated changes in estimates from prior years.

Comments on question 1(iii): Better candidates got full marks. Weaker ones just describedone version of the loss ratio.

(iv) Assume business is written evenly through the year.

Assume that all the policies underwritten are annual.

Assume predecessors estimates are correct.

Assumption relating to how 6% change in premium applies.

Implies earned premium in year to 31 March 2007 =£50m + £50m/1.06 = £97.17m.

Assume loss ratio is calculated on an incurred claims / earned premium basis.

Implies incurred claims

2001: 0.98 × £97.17 / 1.06 6 = £67.13m,2002: 1.02 × £97.17 / 1.06 5 = £74.06m,2003: 1.05 × £97.17 / 1.06 4 = £80.82m,2004: 1.20 × £97.17 / 1.06 3 = £97.90m,2005: 0.94 × £97.17 / 1.06 2 = £81.29m,2006: 0.95 × £97.17 / 1.06 = £87.09m.

Need to assess trend in claims incurred.

Up to and including 2003 can be taken at face value as there are no knownmitigating factors, other than natural variation.

Claims incurred from 2004 onwards need to be adjusted to put them on aconstant cover basis.

Aside from the change to cover, assume the same levels of exposure arecovered each year (that is, assume no other changes).

Assume mix of business unchanged following changes in cover.

Cover came in half way through 2003/04. Therefore the impact may beassumed to affect 12.5% of claims.

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Page 4

However, changes in cover on foundations brought in before the likely influxin claims due to adverse weather conditions, so potential impact of hotsummer should be mitigated on a greater percentage of incurred claims. Say15% (though anything up to, say, 25% may also be considered reasonable).

The defined claim event date will be significant.

This assumes that the incidence of subsidence claims increased significantly because of the heat wave in August 2003 — but after the policy change cameinto force.

Implies claims incurred 2004 would have been (1 / 0.75) × 0.15 × 97.90 + 0.85× 97.90 = £102.80m in the absence of any changes to the cover provided.

Likewise, some claims in 2005 will have originated from the original policywording. So the impact may be assumed to affect 87.5% of claims.

However, the heat wave in August 2003 will affect this assumption, with proportionately more claims likely to be affected by the change in cover. Say95% (though anything from, say, 90% may also be considered reasonable).

Implies claims incurred 2005 would have been (1 / 0.75) × 0.95 × 81.29 + 0.05× 81.29 = £107.03m in the absence of any changes to the cover provided.

All of 2006 will be on the new cover = (1 / 0.75) × 87.09 = £116.11m.

Estimates for new claims incurred = average of all years based on constant(old) cover, reduced to new cover basis.

However, also need to adjust for higher than average incurred in 2003/04 dueto hot, dry summer.

By between 15% and 25%, judging by the numbers given — say 20%

= 0.75 x [ (67.13 × 1.10 6 + 74.06 × 1.10 5 + 80.82 × 1.10 4 + 102.80 × 1.10 3 /1.2 + 107.03 × 1.10 2 + 116.11 × 1.10) ] / 6

= £90.97m. (or alternative sensible calculation based on past results)

However, July 2006 was also exceptionally hot and dry …… so the loss ratio is likely to be markedly higher than the long-run average.

However, the effect could be compounded on top of the 2003 conditions,making the impact worse… or the impact may be less as many problems will already have beenhighlighted in 2003/04 …… and losses will be limited by the changes to cover in 2003.

So, probably by between 15% and 25% judging by the impact of theconditions in 2003 — say 20%.

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Page 5

=> adjusted estimate for new incurred claims = £90.974m × 1.2 = £109.17m.

Expected loss ratio = incurred claims / earned premium

= £109.17m / £97.17m = 1.123.

As a cross-check 1.123 seems reasonable given the trend in loss ratios given inthe question after suitable adjustments have been made.

Comments on question 1(iv): Generally poorly answered. The question required candidatesto perform a number of separate calculations and adjustments to historical estimates toobtain a reasonable estimate of the 2007 loss ratio. Candidates who took the time to set outtheir solution logically tended to identify more of the steps required and so achieve thehighest scores. Candidates were asked to detail any assumptions made. Some candidatesoversimplified the question by inappropriate choice of assumptions, e.g., assuming thatsubsidence claims should be ignored, missing the effects of the policy wording orcontradicting an assumption that was stated in the question. Many candidates attempted toadjust the 2003 and prior years’ incurred claims to put them on a constant basis, rather thanadjusting the later years. Although it is possible to produce a reasonable estimate using thisapproach, few candidates were able to apply it successfully. In both the 2004 and 2005accident years, some claims occur from policies written under the new conditions and some

from policies under the old conditions. Candidates who attempted to adjust only the 2003 and prior years generally did not identify these features of the 2004 and 2005 accident yearclaims.

(v) Business may not be written evenly in the year as more homes are bought andsold during the period April — September, so policy cover is more likely tostart in this period.It will be important to analyse historical patterns of business written todetermine a reasonable assumption.This area of uncertainty will be particularly relevant in light of the timing ofthe hot dry periods and the timing of the change in cover as this is likely toimpact the various proportions of policies on risk affected.

Mix of business may have changed.A more granular split of data could be used, for example, separatingsubsidence claims.

The level of exposure accepted may have changed over time.Example of investigation into level of exposure.

Assumptions regarding the impact of the hot dry summers will be critical tothe estimates,

but are likely to contain significant elements of uncertainty …in particular, the effect of the 2006 summer, for which little data will exist.

It will be important to analyse the pattern of weather / subsidence relatedclaims before and after the dry summers to ensure estimates are as reliable as

possible,and discuss any technical engineering issues with relevant experts.

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Page 6

Your estimates of the impact of the cover changes may contain significantdegrees of uncertainty.Any case estimates may be a particular source of additional uncertainty.Your assumption regarding the underlying increase in incurred claims is likelyto contain significant uncertainty.

However, it should be possible to assess a range of reasonable estimates andassess the impact of difference assumptions on your reserve estimates.

Your predecessor’s estimates of the impact of the changes in cover are likelyto contain a degree of uncertainty.However, good quality data should be available to assess the two subsidencerelated items as claim amount and age of home should be available for allhomes.

May reduce uncertainty by reviewing your predecessor’s analyses of thesechanges.

Obtaining second opinions from a peer reviewing actuary should help toimprove reliability and the level of confidence in any estimates, therebyreducing some of the uncertainty.Estimates can be compared to benchmarks, industry sources, etc.

Comments on question 1(v): Again generally poorly answered with many candidates’answers largely limited to repeating the assumptions listed in part (iv) and noting that eachmay not be valid in practice. Some candidates produced lists of "typical" areas ofuncertainty, for example, noting that it was possible that reinsurance arrangements ortaxation may have changed. Such answers typically did not sufficiently consider the extent towhich assumptions might not be valid, areas of uncertainty and possible ways to improve thereliability of estimates, as requested in the question. Stronger candidates generated a widerange of points.

2 (i) Define Lloyd’s

A society that provides a market place and regulatory frameworkwithin which individual and corporate members may participatein the underwriting of insurance risks on their own account.

Define London Market

That part of the insurance market in which insurance and reinsurance businessis carried out on a face-to-face basis in the City of London.

Comments on question 2(i): Bookwork mostly answered well.

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Page 7

(ii) Describe the main features of Lloyds

Lloyd’s does not act as an insurer in its own right and, therefore, carries noinsurance risk.

The Council of Lloyd’s is responsible for management and supervision of themarket.The Council delegates day-to-day running to the Committee of Lloyd’s, whoare responsible for administrative matters.There is statutory actuarial involvement, and a Lloyd’s actuaryThe FSA regulates Lloyd’s, (as well as Lloyd’s managing agents, members’agents and Lloyd’s brokers).

Members are grouped into syndicates.Members are known as names.

Names can be individual or corporate.Corporate names have limited liability.Most individual names have limited liability……and there can be no new unlimited liability names.

Names are represented by members’ agents.Each syndicate is run by a managing agent.…a company appointed to manage the affairs of the syndicate, appoint theunderwriter, and provide technical and administrative services.Some managing agents are quoted companies listed on the stock exchange,others are private companies.In some instances, managing agents act as capital providers to the syndicatesthey manage so have a dual role as corporate members of the market andmanaging agents.

Business is written through the slip system.Most policy and claims administration is performed by LPSO/Xchanging

The members of a syndicate share the risks written by the syndicate’sunderwriters.However, if a member defaults on their liabilities, the other members of thesyndicate are not responsible for them — there is no joint and several liability.

Because of this, each member is required to provide capital (“Funds atLloyds”) as security to support their total Lloyd’s underwriting business.These funds can be drawn on in the event that the member defaults.

The level of funds required depends on the perceived level of risk in the business which they underwrite, and the amount of business written.The Central Fund is available at the discretion of the Council of Lloyd’s tomeet any valid claim that cannot be met by the resources of any member.Compensation may now also be available from the FSCS.

Each syndicate year of account is allowed to remain “open”, usually for a

period of three years, before a profit or loss can be determined for that year.

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Page 8

During that time, premiums received on business written in the year areaccumulated in a fund, out of which claims and expenses are paid.At the end of the three year period, the fund would usually be closed byestimating the value of the outstanding liabilities and reinsuring them into thesubsequent open year of the syndicate.

The reinsurance premium for this is known as reinsurance to close (or RITC).

Once this transaction has occurred, the final result of the closing year can bedetermined, as can the profit or loss attributable to each member.If liabilities are particularly uncertain, the year of account may be left openlonger than 3 years.

(Almost all) business is written through brokers.Lloyd’s writes all classes of business,in particular special and unusual risksand some business in most countries of the world.

Comments on question 2(ii): This was a straightforward bookwork questions. Full markswere available for candidates who wrote brief notes covering most of the main features. Thecandidates who failed to achieve a good mark typically wrote answers that containedinaccuracies, or focussed on a small number of features of Lloyd's

(iii) Ease of entering market

Megasure Group could participate in an existing Lloyd’s syndicate by just providing capital.Establishing a wholly owned subsidiary would be more complicated.…would need to set-up admin processes / do admin…may not have necessary expertise in house/need to hire staff…and so this may take more time.

This may also lead to a difference in start-up costs of entering market (that is,start-up costs likely to be lower for Lloyd’s).Risk of entering a new market likely to be greater if start-up costs are greater.

Barriers to Entry

It may not be possible for Megasure Group to join the syndicates it wishes to(they may have enough capital already).There may not be syndicates that Megasure Group would like to participate in.

As a major international insurance group, there should not be significant problems in obtaining permission to establish a subsidiary.Should also consider ease of leaving market — may be easier at Lloyd’s.

Control

Lloyd’s syndicates are run by managing agents, who make key decisions such

as appointing underwriters.

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The ability of individual names to control the syndicate may be limited(although Megasure Group’s influence will be greater if it provides asignificant amount of the syndicate’s capital).Megasure could control every aspect of a wholly owned subsidiary, subjectonly to regulatory constraints.

Megasure may have confidential information that a subsidiary could exploit. IfMegasure participated as a name on a syndicate, it may be reluctant to sharethis with the managing agent.

Access to preferred risks

Underwriters on a syndicate may already be writing the type of businessMegasure wishes to write.There may be advantages to writing renewal business on a syndicate thanconsidering risks for the first time at a new subsidiary.The Lloyd’s credit rating may assist Megasure in accessing business.Lloyd’s may give the start-up more credibility than would be attached to asmall start-up (value of Lloyd’s brand).Ability to benefit from Lloyd’s licences.Existing Lloyd’s syndicates would have links to brokers to access risks, andunderwriters may have special relationships.

Diversification

Megasure Group may be able to participate in a number of syndicates,obtaining diversification.

Future strategy

Consider the long term strategy for the European operations. For example, ifmore lines of business are planned in the future, may prefer to operate asubsidiary.

Regulation

There may be differences in the regulatory requirements that make one option preferable.

There may be differences in capital requirements.There may be differences in the permitted assets.

Tax

There may be differences in the tax that make one option preferable.Example of differences.

Expected profitability

There may be differences in the expected profitability that make one option

preferable.

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Comments on question 2(iii): This question required candidates to apply their knowledge of Lloyd's and the London market set out in parts (i) and (ii) to advise Megasure. Candidateswith a good knowledge of the main feature of these markets were able to identify the keydifferences that would likely be of most interest to Megasure and so scored well. A surprisingnumber of candidates indicated that Megasure could only invest with limited liability through

becoming a Lloyd's name. Others suggested that a London market company would not beable to write risks through a slip system. Candidates who did not understand the marketstherefore achieved lower scores.

(iv) Definitions of RMM/MCR, ECR, ICA

RMM — Required minimum margin.MCR — Minimum capital requirement.RMM and MCR are different abbreviations for the capital requirement.RMM/MCR is the greater of the GICR (general insurance capitalrequirement)/RMS (required margin of solvency) and the minimum guaranteefund (MGF) set by the EU.

ECR — Enhanced capital requirement.A more risk sensitive measure than the current EU directive minimum.

ICA — Individual capital assessment.This is a type of capital assessment introduced by the FSA.Insurers are required to carry out regular assessments of the amount andquality of capital that is adequate for the size and nature of their business.

Comments on question 2(iv): Bookwork, however many candidates did not know that RMMis the same as MCR. Most candidates were able to define ICA, and many mentioned that thiswas a type of capital assessment that firms made by considering the risks faced by theirbusiness.

(v) Initial capitalisation of MICE

The MCR/RMM has the force of EU directives, that is, it has the force of law.

This represents the minimum level of capital that must be held.The ECR is currently only a private reporting requirement rather than a hard

test.However, this is under review / may change in the future.In any case, the ECR will be used as a basis of discussions between firms andthe FSA.The ICA represents a firm’s own assessment of its capital requirements, so itis unlikely it would want to hold less than this.

In practice, it is highly unlikely that the FSA would permit MICE to only holdthe MCR/RMM.The ICA is the largest of the three estimates for MICE, so this is probably theminimum level of capital the FSA would permit.

The FSA will review the ICA and issue individual capital guidance.

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ICG will be expressed by the FSA as a percentage of the ECR.The firm would almost certainly want to hold at least the ICG.We don’t know what the ICG will be until the FSA has reviewed the ICA.Therefore it is not possible to know with certainty the capital that MICE willneed.

We could try to obtain information on ICG from other sources to estimate thecapital requirements.

We may want the company to hold more capital than it is required to hold bythe regulator.Additional capital will provide extra flexibility to management.For example, greater flexibility with investment policy.The ICA is an estimate. The company may wish to hold more for prudence.If the company if very thinly capitalised, it may receive unwanted regulatoryattention which could distract management.

Consider how much capital the parent (Megesure) has.Consider the cost of capital of Megasure and the return of MICE under variouslevels of capitalisation. Consider costs of over-capitalisation.Opportunity cost — consider any alternative uses of capital that Megasure has,and the returns on those activities.

Consider alternatives to parent providing capital.The parent could provide a letter of credit rather than capital.The parent could provide addition reinsurance to MICE to reduce its capitalrequirements.However, these alternatives may not be acceptable to the FSA.

Rating agencies — what level of capitalisation does MICE require in order toobtain the desired rating.Do potential policyholders or investors require a particular level of capital /rating in order to place business with the company?Consider the capitalisation/ratings of competitors.Where possible, consider future changes in regulation (for example, SolvencyII)

The estimated capital requirements are higher in 2010 than in 2008.

The company should consider whether it needs to fund future capitalrequirements initially.There may be options that don’t require this to be funded initially, forexample, through retained profits anticipated in the business plan.

Megasure will also wish to finance 2007 start-up costs of MICE.

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Comments on question 2(v): Poorer candidates lack of knowledge really showed here asthey were not able to write very much. Often there was a standard list of things you wouldconsider when deciding how much capital to hold. Better candidates tailored this to thespecific situation and demonstrated their understanding of the capital requirementsnecessary now and in the future. Many candidates stated that firms should consider factors

such as the potential for accumulation of risk or large losses. Such factors would have beenconsidered in producing the ICA, and candidates were expected to refer to this in theiranswers. Candidates who produced standard lists of factors to consider when determiningcapital requirements needs without acknowledging where these were included in the ICAgenerally scored poorly.

(vi) Should reinsurance be purchased?

Purchasing reinsurance with a net cost of £1 million reduces the ICA by £5million.Many of the matters to be considered in deciding on the reinsurance purchasewill have been quantified in the ICA.The company should consider the risk reward trade-off when purchasingreinsurance, that is, the cost of the reinsurance and the benefit to MICE.MICE’s expected profitability will be higher if reinsurance is not purchased(reinsurance premium is saved).This reinsurance does not seem to reduce MICE’s capital requirement by verymuch.As a result, MICE may be better off not purchasing this reinsurance.

Note that there may be a difference between MICE’s capital requirements andthe ICA estimates (e.g. ICG). £5 million may not be the figure for Megasure toconsider.Consider whether the parent has the extra capital available that would berequired if reinsurance is not purchased.…and what is the opportunity cost of the extra capital.

MICE’s profits will be more volatile without reinsurance.Consider whether Megasure (and its shareholders) prepared to accept morevolatile profits in return for higher expected profitability.

Consider any rules Megasure has regarding the reinsurance purchased by its

subsidiaries.Megasure is also a reinsurer, so accepting an internal reinsurance may beconsistent with its risk tolerance.

The ICA amounts are estimates, and may have underestimated the benefit ofthe reinsurance.Although the reinsurance may not reduce the ICA by much, there may beother benefits.Example of other benefits: e.g. may not reduce the ICA by much, but mayreduce ruin probability significantly.The reinsurance premium estimated in the business plan may be wrong.

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Need to find a way to assess experience.Experienced staff will be expensive.

Have internal peer review process.Should focus most attention on largest risks.

May not be possible if need to respond to brokers quickly, but can applyresults of peer review to future underwriting decisions.

Add margins to rates to reduce possibility of rate inadequacy.Rates may become uncompetitive.Ensure adequate premium loadings (commissions, expenses, reinsurance etc.)

Comment on practicality of monitoring loadings.

Monitor changes in volumes and other movements.May be difficult to identify reasons for any changes.

Monitor insurance cycle.May be difficult to accurately determine the position of the market in thecycle.

Monitor prices charges by competitors as a check on your own model.It may not be possible to access this information.Competitors may be charging the wrong rates.

Comments on question 2(vii): The key features of MICE are that it is a new company, and itis writing London market property business. Candidates were expected to identify methods ofmonitoring pricing that are appropriate to such a company, and comment on the practicality.

Ensuring the reasonableness of the loadings for investment income and fixed expenses wouldtend to be less important for MICE than some of the other factors identified in the solution.Some candidates devoted most of their answers to expenses and investment income and soomitted to mention other important considerations. Weaker candidates produced answersthat didn't reflect the nature of commercial property insurance or were a standard how to

price a product answer.

(viii) Extra line of business

Regulatory considerations.FSA would have to reconsider the authorisation (unless it was alreadyauthorised for the new line as part of the original process).A sudden change in the business plan may create a bad impression withregulator.

Characteristics of new marketFor example, size, growth, ease of entry, relationships.

Capital requirements of new line of business.Is this capital available?

Opportunity cost of capital.

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Expected profitability/return on capital of new line of business.

Consider whether new line is consistent with MICE’s risk appetite.There may be a diversification benefit of writing lines of business with lowcorrelations.

Synergies with existing book.

Does company have sufficient expertise to write this line of business?Would writing a new line of business distract the company from itscommercial property targets?It might be better to defer introducing a new line until the company has beenestablished for a couple of years.

Consider views of parent.For example, in raising the profile of the new business.Consider views of rating agency.Reinsurance requirements of new line of business.Consider potential for cross-selling.Consider whether system changes would be required.Consider any tax issues.

Comments on question 2(viii): This question was generally well answered.

END OF EXAMINERS’ REPORT

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EXAMINATION

1 October 2007 (am)






You are strongly encouraged to use this time for reading only, but notes may be made.You then have three hours to complete the paper.

3. You must not start writing your answers in the booklet until instructed to do so by thesupervisor.

4. Mark allocations are shown in brackets.

5. Attempt all 3 questions, beginning your answer to each question on a separate sheet.

6. Candidates should show calculations where this is appropriate.

AT THE END OF THE EXAMINATION

Hand in BOTH your answer booklet, with any additional sheets firmly attached, and thisquestion paper.

In addition to this paper you should have available the 2002 edition of theFormulae and Tables and your own electronic calculator.

© Faculty of ActuariesSA3 S2007 © Institute of Actuaries

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SA3 S2007—2

1 A student has produced the following tax calculation for a UK resident proprietarygeneral insurance company. The company writes only UK business.

Accounting Student'sInvestment Returns Data Calculation

Purchase price of fixed interest securities 500.0Market value of fixed interest securities as at 1/1/2006 625.0Market value of fixed interest securities as at 31/12/2006 620.0Accrued investment income during 2006 25.0

Return on fixed interest assets 145.0

Purchase price of UK equities 30.0Market value of equities as at 1/1/2006 55.0Market value of equities as at 31/12/2006 60.0

Net dividend income during 2006 2.0

Return on UK equities 32.0

Underwriting ResultUnearned premiums b/fwd 45.0Written premiums 100.0Unearned premiums c/fwd 50.0

DAC b/fwd 9.0Acquisition costs paid 18.0DAC c/fwd 10.0

Reinsurance purchased on 1 January for 2006 20.0

Earned Premiums net of DAC and Reinsurance 56.0

Outstanding and IBNR claims b/fwd 485.0

Net Claims paid in 2006 60.0Outstanding and IBNR claims c/fwd 475.0

Allowable Equalisation reserve transfer 10.0Additional provision for future catastrophes 4.0

Claim handling expenses incurred in 2006 3.0Provision for future claim handling expensesfor claims incurred in 2006 5.0

Increase in claims and claims provisions 72.0

Staff and buildings costs 10.0

Underwriting Result 151.0

Tax @ 30% 45.3

Underwriting result after tax 105.7

Correct the student’s tax calculation and state the underlying principles that explainhow each accounting item should be treated. You may ignore any interimarrangements and can assume that the accounting items given are correct. [11]

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SA3 S2007—3 PLEASE TURN OVER

2 Company A is a large insurance group with worldwide operations. One of its smallsubsidiary companies, Company B, is a UK company that started writing international

property and liability reinsurance business in 1950. Company B took the decision to pull out of the US reinsurance market in 1980 and since then has focused on writing asmall and very profitable European property reinsurance book. Company B’sdiscontinued portfolio currently consists largely of US Asbestos, Pollution and HealthHazard (“APH”) liabilities. In recent years, Company A has needed to inject more

capital into Company B following reserve deteriorations on the US APH liabilities.The technical reserves for Company B are established on a discounted basis.

The Board of Company A is currently considering selling Company B in view ofCompany A’s worldwide strategy to focus on writing direct business.

(i) Describe the major areas of risk facing Company A in respect of the APHclaims liabilities of Company B. [7]

(ii) Suggest the benefits to Company A of selling Company B. [5]

(iii) Discuss alternative options open to Company A to remove the risks of the

APH liabilities within Company B, explaining their advantages anddisadvantages. Company A has already dismissed the use of an adversedevelopment cover. [10]

Company C has shown an interest in acquiring Company B’s APH liabilities fromCompany A. Company C has proposed that it acquires the APH liabilities in returnfor the transfer of assets equivalent to the discounted claims reserves (includingclaims handling expenses) on a High estimate basis, where High estimates are deemedadequate in 90% of future possible outcomes.

The company actuary for Company B has provided the following estimates in respectof the APH liabilities as at 31 December 2006.

Best estimate reserves High estimate reservesFigures in US$m Case

reserves

Annual Average Paid(last 3 years)

Undiscounted Discounted4%

Undiscounted Discounted4%

Asbestos 12.8 2.7 51.3 34.5 77.0 48.8Pollution 12.1 4.5 24.1 19.8 36.2 29.7Health Hazards 1.0 0.8 2.0 1.8 3.0 2.5Subtotal 25.9 8.0 77.4 56.2 116.1 81.0Claims handling expenses 1.0 3.1 2.5 4.6 3.8Total 9.0 80.5 58.7 120.7 84.8

Company B’s assets have produced investment return averaging 4.2% per annum overthe last 3 years.

(iv) Suggest the benefits to Company C of acquiring the APH liabilities. [5]

(v) (a) Estimate the discounted mean terms of each claim type on each of theBest estimate and High estimate bases.

(b) Comment on the reasonableness of the relative length of thesediscounted mean terms. [9]

(vi) Set out the challenges that you would make in regard to the numbers in the

table above when assisting Company C in its initial price negotiations for this portfolio. [9][Total 45]

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SA3 S2007—4

3 You have recently joined a large general insurance company and you are determiningthe reserves for a portfolio of business in the first quarter of 2007, using annual dataas at 31 December 2006. The company business plan for the 2004 year shows a

planned ultimate loss ratio of 85%. The company stopped writing this portfolio at theend of 2004.

You have the following summary information readily available:

Underwriting Years2000 2001 2002 2003 2004 2005 2006

Premiums £ million 17.2 17.4 17.6 18 20.1 0 0Reported loss ratio 87.0 82.0 69.0 50.0 34.6Basic chain ladderultimate loss ratio %

90.5 93.0 90.0

Booked ultimate loss ratio % 91.0 93.0 89.6 92.0 85.0A priori * loss ratio % 91.0 93.0 89.6 92.0 85.0Mean term of paid claims

In years

4.0

Development year 1 2 3 4 5 6 7 8 9Age to age factors n ton + 1(reported claims) 10.00 3.00 1.80 1.40

1.15 1.09 1.03 1.01 1.00

* a priori in this context refers to the initial estimate ultimate loss ratio used in theBornhuetter-Ferguson calculation

As part of your review you investigate other sources of information. You discoverthat:

• The 2003 and prior years are running off as planned.

• A company pricing database shows that the average rate change across policies in2004 is minus 10%.

The ex-underwriter of the account tells you that he feels that rates were showing a tento fifteen percent reduction and that some policies had wordings which gave widercoverage than in previous years.

(i) (a) Calculate the Bornhuetter-Ferguson and chain ladder estimatedultimate loss ratios for the 2003 and 2004 years.

(b) Comment on the difference between the Bornhuetter-Ferguson andchain ladder expected ultimate claims.

[6]

(ii) (a) Derive three alternative a priori loss ratios for use in the Bornhuetter-Ferguson method for the 2004 year.

(b) Calculate three alternative Bornhuetter-Ferguson ultimate loss ratios

using your estimates from part (a) and tabulate your results. [5]

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SA3 S2007—5

(iii) (a) State the concerns that you would have with the 2004 initial a prioriloss ratio and the new a priori loss ratios you have derived in part (ii).

(b) Comment on the calculated ultimate loss ratios. [9]

The company finance director tells you that it has always been company practice to use the budgeted loss ratios in the Bornhuetter-Fergusoncalculations. He has seen your table of results and states that the Bornhuetter-Ferguson method is not credible as it can give any result that you may want.He tells you that he intends to use the ultimate claims using the budgeted lossratio in the Bornhuetter-Ferguson calculation.

(iv) Discuss the finance director’s comment on the credibility of theBornhuetter-Ferguson method. [5]

(v) (a) Select one a priori ultimate loss ratio for the 2004 year and calculate

the increase in reserves needed if the company changes its a priori lossratio to your figure and

(b) Comment on the materiality of this difference if the company followsits usual practice. [5]

A broker has approached the company offering to arrange an adversedevelopment cover to reinsure this portfolio at a price that you estimate to be

best estimate loss cost plus 30% load plus brokerage.

(vi) Explain the term adverse development cover. [2]

(vii) Explain the risks to the ceding company of reinsuring this portfolio and the

risks to the reinsurance company of writing this portfolio and explain whateach company can do to mitigate its risks. [9]

(viii) State with reasons whether you think that such a policy would be appropriatein this situation. [3]

[Total 44]

END OF PAPER

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EXAMINATION

September 2007

Subject SA3 — General Insurance

Specialist Applications

EXAMINERS’ REPORT

Introduction

The attached subject report has been written by the Principal Examiner with the aim ofhelping candidates. The questions and comments are based around Core Reading as theinterpretation of the syllabus to which the examiners are working. They have however givencredit for any alternative approach or interpretation which they consider to be reasonable.

M StockerChairman of the Board of Examiners

December 2007

Comments

Individual comments are shown after each part-question

© Faculty of Actuaries© Institute of Actuaries

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1Corrected

Investment Returns Calculation

Purchase price of fixed interest securities 500.0Market value of fixed interest securities as at 1/1/2006 625.0Market value of fixed interest securities as at 31/12/2006 620.0Accrued investment income during 2006 25.0

Return on fixed interest assets ={Accrued investment income} + {MV @ 31/12/2006} - {MV @ 1/1/2006} =25 + (620 - 625) = 20 20.0

Purchase price of UK equities 30.0Market value UK equities as at 1/1/2006 55.0Market value of UK equities as at 31/12/2006 60.0

Net Dividend income during 2006 2.0

Return on UK equities ={Net dividend income} + {MV @ 31/12/2006} - {MV @ 1/1/2006} =2 + (60 - 55) = 7 7.0

Underwriting ResultUnearned premiums b/fwd 45.0Written premiums 100.0Unearned premiums c/fwd (50.0)

DAC b/fwd (9.0)Acquisition costs paid (18.0)

DAC c/fwd 10.0

Reinsurance purchased on 1.1 for 2006 (20.0)

Earned Premiums net of DAC and Reinsurance ={Unearned Premiums b/f} + {Written Premiums} - {Unearned Premiums b/f}- {DAC b/f} - {Acquisition costs paid} + {DAC c/f}- {Net Cost of Reinsurance} =45 + 100 - 50 - 9 - 18 + 10 - 20 = 58 58.0

Outstanding and IBNR claims b/fwd 485.0 Net Claims paid in 2006 (60.0)Outstanding and IBNR claims c/fwd (475.0)

Allowable equalisation reserve transfer (10.0)Additional provision for future catastrophes 0.0

Claim handling expenses paid in 2006 (3.0)Provision for future claim handling expenses for claims incurred in 2006 0.0

Increase in Claims and claims provisions ={OS & IBNR b/f} - {Net claims paid} - {OS & IBNR c/f}- {Allowable equalisation reserve transfer} - {CHE} =485 - 60 - 475 - 10 - 3 = -63 (63.0)

Staff and buildings costs (10.0)

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Technical Result ={Fixed interest return} + {Equity Return} + {Net Earned Premiums}– {Increase in paid claims and claims provisions paid} =20 + 7 + 58 – 63 – 10 = 12 12.0

of which no further tax due on dividend income 2.0

Taxable result = 12 – 2 = 10 10.0Tax @ 30% = 10 × 0.3 = 3.0 (3.0)Underwriting result after tax = 12 – 3 = 9.0 9.0

Alternative solution:Gross Earned Premium 100-(50-45) = 95

Less Earned RI (20) Net Earned Premium = 75 Incurred Claims 485-60-475 = (50) Allowable Expenses 31 Increase in DAC 1Underwriting result = (5)Taxable fixed interest return 20Taxable return on equities 5

Equalisation reserve provision (10)Taxable result = 10Tax @ 30% (3)Franked income from equities 2Technical result after tax = 9

• Investment Return From Bonds or “Loan relationships” is taxed on the total returns whether

realised or unrealised. The bonds are valued on a mark to market basis.Dividends from UK equities are not taxed further. Gains are taxed on a markto market basis.

• Underwriting result taxable as follows: Earned Premiums (net of RI), so unearned premiums net of DAC tax

deductible Expenses are tax deductible (acquisition costs, running costs of the business,

…) Less claims handling expense provision is allowable to the extent that the

expenses relate directly to claims for which claims provisions have beenaccepted by HMRC.

Less paid claims Less change in o/s claims carried forward supported by case estimates or

statistical projections Change in IBNR subject to justification

Sensible mention of discounting.The insurance technical provisions claimed for tax purposes are net of amountsrecoverable from reinsurers.For tax purposes it is necessary to assume that all amounts due will be recovered.A deduction is allowed for specific provisions for amounts estimated to beirrecoverable from reinsurers but a general provision is not allowed.

In the UK, insurers are required to establish an Equalisation Reserve/provision overand above their claims provisions in respect of certain classes of business (regarded as

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being potentially volatile). Statutory rules govern the calculation of transfers to theReserve (which are tax deductible) and transfers from the Reserve (on which tax is

payable).

Provisions for future catastrophe losses are not allowable except where required by

law

Comments on Q1 . The template given should have guided the layout of the answerrequired. A minority of students followed this template and scored well. Those whochose their own format often made mistakes and the answers were harder to follow.

Most candidates showed a reasonable grasp of the basics concerning equities andbonds returns and made a decent effort at correcting the calculation. However, very

few candidates made many sensible comments on the principles of taxation ( e.g. IBNR is deductible only subject to justification, change in outstanding claims isdeductible provided that supported by case estimates or projections) so very fewcandidates scored highly on this question.

2 (i) APH risks • Claims reserves very uncertain because APH liabilities are long tailed due

to long latency period (could be inadequate)• Liabilities stem from early years when policy records may be incomplete:

difficult to assess full extent of exposuresLiabilities increase leaving the reserves inadequate due to: (need reason)• Risk of legal judgements increasing liabilities• Change to regulatory environment• Risk of new latent diseases emerging thus increasing liabilities• Propensity to claim• Claim inflation higher than expected• Gearing for RI policies• Risk of accumulations• Risk around the value of the discount within the discounted reserves:

+ Timing of claims payments is uncertain — can be difficult to assesscashflows

+ May not achieve return on assets implied by discount rate.• Currency risk if liabilities not matched

• Mismatching of assets and liabilities• Risk of disputes and bad debt on outwards reinsurance given the age of theliabilities

• Claims handing cost could be higher than expected (for various reasons,legal, cost of specialist handlers etc…)

Comments on Q2 (i). This was answered well by most candidates.

(ii) Benefits of sale • Removes risk of further reserve deterioration on APH• More stability (less volatility)• No longer distracts Company A management from ongoing business —

frees up resources (future strategy)

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• Brokers, potential customers and rating agencies may have undervaluedCompany A because of APH liabilities of B

• Sale of B may result in enhanced sale value of A…• …and increase ability to issue debt• Administrative savings• Extract capital from Company B (less capital needed)• May get a good deal

Comments on Q2 (ii). This was answered reasonably well.

(iii) Alternative options

• Part VII transfer to external company (or, alternatively, for Loss PortfolioTransfer and Novation)+ legal liability transferred

+ so employee and shareholder rights not affected+ may improve the sale terms of Company B+ can transfer to specialist APH run-off company+ don’t have to transfer non APH policies

– need to get regulatory/court approval which can be time consuming – possible reputational risk− will need to commission an independent expert to opine on

policyholder protection− this could be expensive

• Proactive commutation of policies+ does not normally require regulatory approval+ opportunity to make profits on individual policies

– can be time consuming and needs senior input – will be impractical to commute all the policies and unlikely to be able

to remove all exposures this way• Scheme of arrangement

+ Can achieve finality+ Do not have to get agreement from every policyholder

– May be reputational issues for Company A if scheme fails or seen to be unfair

– Can take some time to set up

– May not have expertise in house to plan or execute

Comments on Q2 (iii). This was poorly answered. Many candidates gave answers thateither would not remove the liability from the company (e.g. ring fence within company)or were very unlikely to be realistic or practical. Those candidates that did suggest a PartVII transfer or a scheme of arrangement often did not give sufficient further detail. Thewording of many candidates’ answers gave the impression that the portfolio could be soldand all associated capital would be released. If such a transfer were to take place then a

premium over the reserves will almost certainly be paid and this could be greater thanthe capital held. Loss portfolio transfers answer the question correctly only if theytransfer legal liability. In the UK this is called a Part VII transfer, other legislationexisting in other counties.

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(iv) Benefits of acquiring

• Make a profit and/or diversify but VERY unlikely best estimate reserves may be prudent following reserve injections actual investment return is greater than assumed in the value of the

discount deal done on high estimate basis, for which reserves are an additional50% on best estimate

• Expertise to be able to assess risks and price portfolio• May have experience of doing schemes of arrangement• May have own APH department so gain from economies of scale• May have specialist claims handling and commutations expertise• Bargaining power for class actions, set-off rights with brokers and

reinsurers• Better bargain with claimants if not involved in writing current business

Comments on Q2 (iv). Most candidates did not give enough weight in their answers to thebenefits of scale, expertise and bargaining power of a specialist company taking on this

portfolio.

(v) (a) Estimate discounted mean term• Discounted reserves ~ undiscounted reserves ×

(1 + interest rate) - DMT • So DMT can be estimated by

ln(undiscounted/discounted)/ln(1 + discount rate)

Liability Type Best DMT

High DMT

Asbestos 10.1 11.6Pollution 5.0 5.0Health Hazard 2.7 4.6Claim Handling

Expenses 5.5 4.9

(b) Reasonableness:

Asbestos DMT higher than others reflecting longer latency period of asbestosSome of pollution liabilities relate to clean up costs, which are not bodilyinjury claims so slightly shorter than asbestosPollution mean term could be a bit shortPollution best = high could be an error (or other sensible comment)Health hazards DMT would depend on claim type but expected to be shorter

tail than asbestosHealth Hazard estimated DMT seems too low: may be errorHealth Hazard is more dependent on latent claims (IBNR) as low ratio of paidclaims to case reserves therefore expect a bigger difference between best DMTand high DMT

Asbestos High DMT > Best DMT

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May be reasonable if assume longer payment pattern accompaniesdeteriorating experience

Because it would take time to deteriorate Reasons for deterioration : more new claims reported than expected

inflation of average claims costs higher than expected

more mesothelioma claims (longer latency period and higher averagecost)

Comments on Q2 (v). A surprising number of candidates were unable to calculate the DMT’s and those that were able to do the calculation typically made only briefcomments.

(vi) Challenges

• Company C wants the amount of assets transferred to be as high as possible therefore challenges should focus on increasing discounted Highestimates

• Discount rate may be too high and therefore discounted High reserves toolow need to allow for risk of past returns not being achieved in future especially as need to consider long future payment patterns

• Nature of liabilities => outcome is very uncertain• Calculation of IBNR to OS ratios• Calculation of survival ratios• Ratio between High and Best reserves is the same at 1.5 for all claim types

How likely is it that the High estimates represent the 90th percentile?• Data provided are inadequate – would want to see lots more (need valid

example of extra data) Asbestos probably more uncertain than pollution due to longer latency

and mean term to settlement => may need to increase High estimate for asbestos

• Based on average claims payments, Health Hazards reserve could beexhausted in 2.5 years.

• How to allow for possibility of later emergence of claims e.g. lead paint,new claim types?

• Survival ratio for Claims handling expenses is just over three years, farless than the DMT’s would suggest. Claims handling expense reserveappears to be understated.

• The ratio of High to Best undiscounted reserves is the same for claimshandling expenses as for claims reserves. You might expect claimshandling expenses to be proportionately higher than this in view ofreducing economies of scale as time goes on

• What downside scenarios have been considered in assessing the range? E.g. US legal developments Rapid increase in claims inflation

Comments on Q2 (vi). Candidates missed many obvious challenges in this question and

most did not consider calculating survival or IBNR to outstanding ratios

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3 (i)

development year 1 2 3 4 5 6 7 8 9Age to age factors n ton+1(reported claims) 10.00 3.00 1.80 1.40 1.15 1.09 1.03 1.01 1.00

Age to ult factor 3.286 1.826 1.304 1.134 1.040 1.01 1.00

1/cumf 0.304 0.5481 - 1/cumf 0.696 0.452

BCL for 2003 = 50 × 1.826 = 91.3BF for 2003 = 50 + 0.452 × 92 = 91.6BCL for 2004 = 34.6 × 3.286 = 113.7BF for 2004 = 34.6 + 0.696 × 85 = 93.7

Chain ladder does not take account of prior expectations and therefore projects theultimate without adjustment.2003 91.6 because a priori loss ratio in line with experience2004 113.7 because a priori not in line with experienceIt is the same as using the bf method with an a priori ultimate of 113.7%The BF method is credibility weighted to take account of prior knowledge.BCL could be distorted by one or two large claims hence big differenceIf the a priori estimate is closer to the real ultimate then theBF method will give amore accurate result and vice versaWhich means that great care needs to be taken in selecting the a priori estimate.

Comments on Q3 (i). All candidates should have scored full marks for the technical partof the reserving calculations. However, some candidates did not appear to know how to

perform a BF calculation and others calculated it in a very inefficient way thus wastingvaluable time. Also basic errors were made by some candidates.

(ii) (2003 and 2004 booked starting points given in the table below. 2003 is a better starting point given the implausible 2004 number. There are other validstarting points including prior year basic chain ladder estimated ultimate lossratios.)

(Increase in reserves shown here for part v calc)There are alternative starting points e.g. 2003, BCL…….Correct application of rate reductions:Calculation of ultimates:Clear tabulation of results

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Comments on Q3 (ii). Almost all candidates were able to select three ratios for use in the BF. Some candidates were happy to select unhelpful a prioris (ignoring informationgiven) or made selections which were near-identical (e.g. comparing a volume weightedaverage with a simple average) missing the much greater uncertainty in otherassumptions. The better candidates recognised that the key issue is one of uncertainty andcalculated a range of a priori estimates accordingly . Mistakes were often made in thecalculation of rate change impact. The better candidates recognised that there may wellbe claims trend in addition to the rate weakening. Many candidates dropped easy marks

for not tabulating the results as instructed.

(iii) Original loss ratio

Original (budgeted) a priori loss ratio is now over three years old.And we have newer information which suggests that this estimate isoptimistic.And could easily be 30 points out, significantly distorting the ultimate

Need to ask questions about currency of claims as could cause distortions

New estimate a priori loss ratios

The pricing database is an unknown to us and we do not know how the figuresare calculated. Example required of why this may be a problem, e.g.

granularity.Assuming the calculations are correct then this estimate is very different tothat assumed in the budgetBudget assumes approximately 8% rate increase compared to 10 pointdecrease, an 18 point gap.It is unlikely that the rate changes due to wording changes will be accuratelyrecorded, if at all.The rate reduction may well be calculated as a change in premium per unit ofexposure which will not take into account inflation of loss cost over the year,in which case the rate change will be worse by the amount of loss inflation(e.g. 4%)

a priori LR bf ult

increase inreserves from bfult of 93.7(using an 85 apriori LR)

increase inreservesfrom 85%bookedloss ratio

using 200 3 as a base

with 10% rate reduction 92 ---> 102.2 105.7 2.41 4.16with 15% rate reduction 92 ---> 108.2 109.9 3.25 5.00with 20% rate reduction 92 ---> 115.0 114.6 4.20 5.95with 30% rate reduction 92 ---> 131.4 126.0 6.49 8.25

using 200 4 as a base

with 10% rate reduction 85 ---> 94.4 100.3 1.32 3.08with 15% rate reduction 85 ---> 100.0 104.2 2.10 3.85with 20% rate reduction 85 ---> 106.3 108.5 2.97 4.73with 30% rate reduction 85 ---> 121.4 119.1 5.09 6.85

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The underwriter’s estimate will probably be influenced (biased) by thecalculated rate change and the poor experience of the portfolio to date, and itis likely that his figure is based on some of the larger and more memorable

policies in the portfolio. However, his judgement seems to be credible.The difficulty is in knowing how much to add for the widening of policy

coverages but bearing in mind that rate reductions are normally under-estimated in a softening marketThe true rate softening could easily be double the estimated 10%. This is moreworrying given the sudden increase in the portfolio premiums from anotherwise stable position.

Ultimate loss ratio

The reported to date loss ratio for 2004 would suggest an ultimate loss ratiosignificantly higher than 85% using BCLUsing the 10% reduction gives a loss ratio 15 points higher (or alternativesuggestion)With different plausible assumptions there is a large range in the calculatedanswersBCL could be distorted by one or two large claims hence making a bigdifference so it could be difficult to settle on one estimateThe range gives us significant concern over the budgeted ultimate.as 85% is

below the bottom of our range.

Comments on Q3 (iii). Very few candidates raised questions on the pricing database andthe way it calculates a rate change. Also many candidates did not discuss the difficulty oftaking account of the underwriter’s comments appropriately. Several candidates chose todismiss the underwriter’s views entirely and thus discarded a valuable source ofinformation. Most candidates got very low marks on this part.

(iv) It is true that the BF method relies heavily, even critically, on the a prioriestimate which is a strength if the a priori is chosen well and a weakness ifchosen badly.Indications are that the selected a priori estimate needs revision as evidenced

bythe high reported loss ratio for a year at the end of 36 months

the rate reduction estimates in the databaseand from the underwriterThe company should be trying to book best estimate results which meansusing the best information available and should take precedence over anestablished practice which in this instance looks like it is not giving a goodsolution.

Comments on Q3 (iv. Most candidates made some reasonable points in discussing the BFreliance on its a priori. However, few candidates stated clearly that reserves should becalculated as best estimates using the most up to date information. Most candidates gavea general description of the BF method and failed to tailor their answer to the specific

circumstances given in the question and thus missed many easy marks. There wassignificant misunderstanding of what independent means in relation to the BF method.

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A commonly held incorrect view was that no information derived from the year inquestion could be used. Rate changes, claims inflation, wider wordings and increasing

premium volume are all ” independent” and should be used in determining a bestestimate a priori.

(v) For calculation of reserve deterioration see above tabulation

Selecting one number: e.g. 20% rate reduction on 2003 gives a priori loss ratioof 115%. This gives an ultimate loss ratio of 114.6%The increase in reserves is the change in IBNRSo the reserve deterioration is the premium multiplied by the change in ULR= 20.1 x (114.6% - 85%) = 5.95m

Calculating reserve deterioration :Ultimate claims are approximately 90m × 92% = 83m for the portfolioAssume paid claims are at 25% which means reserves are about 62mThen the increase in reserves will be about 5.95/62 = 9.6%This has borderline materiality for this portfolio but will be immaterial for thewhole company. One should check that this is an isolated instance and notsystematic, in which case the overall impact may well be material.

Comments on Q3 (v). Most candidates were able to calculate the reserve deteriorationbut very few considered paid claims and therefore the likely impact on unpaid claims.Further a surprising number of candidates did not pick up that for a large company thisdeterioration in itself is unlikely to be significant.

(vi) Adverse development cover pays for the deterioration in claims over aspecified period in excess of a pre-agreed amount.The deterioration can be measured using paid claims or reported claimsThe specified period would normally be more than one year.It is usual for the ceding company to retain a share of the claims i.e. less than100% is ceded.

Comments on Q3 (vi). Most candidates appeared to know broadly what an adversedevelopment cover was, but missed the detail.

(vii) Risks to ceding company:

Claims experience is better than expected and the company pays the claimsand the reinsurance premiumClaims could deteriorate outside of the period of cover and therefore not bereinsured.Claims could deteriorate badly and the company’s retained share could still besignificant.The reinsurer could fail

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Mitigated by:

Negotiating the lowest premium possibleRetaining the minimum possible shareSpreading the ceded risk amongst several reinsurers

Using only top credit rated reinsurers

Risks to the reinsurerUnderwriting risk — takes on a risk which is worse than anticipated at too lowa premiumTiming of claims happens inside the covered periodLegislation/judicial decisions/interpretation mean that the original policieshave wider coverage than expected, and hence claims more than expected.which may accumulate with other risks that it has.There may be significant latent claims in the portfolio.Currency fluctuations could make the claims larger than expectedInvested assets may perform worse than assumed in any calculation of

premiums.Moral hazard from the cedant, manipulating claims payment/reporting to fallwithin the policy period.

Mitigated by:Thorough analysis and investigation of the policy and claims filesPurchasing reinsuranceCareful monitoring and limiting of aggregatesHedging of currencyDiversification of assetsParticipation clauseIncrease profit marginClaims audits to verify no changes in claims procedures.

Comments on Q3 (vii). Most candidates gave reasonable answers, but only identified a few of the risks to the reinsurer.

(viii) I would not think that buying this policy would be appropriate in this instance.(or clear statement of opposite opinion)All years except for 2004 seem to be running off to the recognised pattern

With the exception of 2004….which will attract more scrutiny and a higher premium anyway.The total reserve size is small and any adverse development is likely to bemuch smaller

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So unless the company’s solvency is very tight this does not look like a goodoption as the company will be ceding profit and paying brokerage when thecompany should be well able to pay the claims without reinsurance.

Comments on Q3 (viii). Many candidates answered this well. However some lost marks

by not stating a clear preference on whether the cover is appropriate in this case.

END OF EXAMINERS’ REPORT

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EXAMINATION

14 April 2008 (pm)






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