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Faculty of Actuaries Institute of Actuaries

EXAMINATION
7 April 2005 (pm)
Subject ST2 Life Insurance
Specialist Technical
Time allowed: Three hours
INSTRUCTIONS TO THE CANDIDATE
1. Enter all the candidate and examination details as requested on the front of your answer
booklet.
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 the
supervisor.
4. Mark allocations are shown in brackets.
5. Attempt all 8 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 this
question paper.
In addition to this paper you should have available the 2002 edition of the
Formulae and Tables and your own electronic calculator.

Faculty of Actuaries
ST2 A2005 Institute of Actuaries
ST2 A2005 2
1 Outline the ways in which the government of a country may use its fiscal regime to
increase the consumer demand for savings products of life insurance companies. [4]
2 Describe the key considerations in setting the terms for a without profits policy
alteration. [5]
3 A without profits whole life assurance policy with sum assured of 20,000 is to be
issued to a male life currently aged 50. The policy has an option such that at the tenth
policy anniversary the policyholder may take out a further whole life assurance policy
for a sum assured of 20,000, at the company s standard premium rates and without
evidence of health.
Benefits are paid at the end of the year of death. Basic premiums are paid annually in
advance throughout life, under all policies. The additional premium is payable until
the option date, or until earlier death.
The company uses the following basis for calculating premium rates:
Mortality after exercising: AM92 Ultimate mortality with ten years added to
actual age
Standard mortality: AM92 Select
Interest: 4% per annum
Expenses: None
Proportion exercising option: 30% of all policyholders
Calculate the additional annual premium that should be paid for the option. [8]
4 Describe how the principal actuarial investigations help to manage risks in a life
insurance company. [11]
ST2 A2005 3 PLEASE TURN OVER
5 (i) State the principles a life insurance company should follow when establishing
supervisory reserves. [3]
A life insurance company sells only conventional with profits life insurance contracts.
It uses a net premium method for its statutory valuation.
(ii) Describe the extent to which the net premium method meets the principles for
establishing supervisory reserves. [5]
(iii) The value of the assets backing the with profits liabilities has fallen by 25%
since the last valuation.
Explain why the statutory value of the liabilities is unlikely to have fallen by
the same percentage. [5]
[Total 13]
6 A life insurance company sells unit-linked products through insurance intermediaries.
The government of the country in which the company operates is to introduce new
legislation. This will restrict the charges that can be applied to group endowment
assurances sold to employers for the purpose of providing retirement benefits for
employees.
The maximum charges that can be applied to a policy will be at a fixed rate
throughout the policy term, and can be either:
(a) x% per annum of the value of the unit-linked fund, and no other charges or
penalties; or
(b) y% of each premium invested, and no other charges or penalties
An employer is only permitted to have one such endowment assurance policy, but
may transfer an existing policy.
The insurance company has decided that it wishes to continue to operate in this
market, but its current product offering does not meet the proposed maximum charge
regulations.
Discuss the factors that the insurance company should consider when designing its
new group endowment assurance product. [17]
ST2 A2005 4
7 (i) State the principles of investment that a life insurance company should adhere
to when determining its investment strategy. [2]
A life insurance company, which operates in a highly developed economy, has
experienced a deteriorating solvency position for a number of years.
Two of the contracts the company writes are:
(a) A unitised with profits single premium pensions contract with a term of 10
years. The contract offers a minimum guaranteed death benefit of the initial
single premium plus 2% per annum compound for each complete year the
premium was invested. On maturity there is a return of premium paid plus a
mixture of regular and terminal bonuses. The terms on surrender prior to the
end of the ten year period are not guaranteed.
(b) An immediate annuity contract, where a fixed level amount is paid each month
to the annuitant until his/her death. In addition, the life insurance company
guarantees to pay an amount equal to five times the annual annuity amount
less annuity payments received should the annuitant die within the first five
years of taking up the annuity.
Discuss the factors the company might take into account when deciding on the assets
it might invest in to meet the investment principles outlined in (i) for the:
(ii) unitised with profits contract [11]
(iii) immediate annuity contract [7]
[Total 20]
ST2 A2005 5
8 For a number of years a life insurance company has sold unit-linked savings policies
with a term of 10 years.
Premiums in the first two years are invested in capital units and after that period are
invested in accumulation units. Both types of unit have a bid offer spread and an
annual management charge. The annual management charge on the capital units is
higher than that on the accumulation units.
On death, maturity or surrender the policyholder receives the bid value of units.
The company is using the annual management charge on the capital units as the
variable in its profit testing in order to meet its profit criterion.
Over recent years the company has experienced deteriorating solvency.
(i) Discuss how well the charging structure is likely to match the expense
cashflows of the company. [12]
(ii) Discuss how the matching might be improved by actuarial funding, describing
any changes to the policy design that would be required. [6]
(iii) Discuss how the policy proceeds to the policyholder might change as a result
of the changes described in (ii) above. [4]
[Total 22]
END OF PAPER
Faculty of Actuaries Institute of Actuaries
EXAMINATION
April 2005
Subject ST2 Life Insurance
Specialist Technical
EXAMINERS REPORT
Introduction

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

M Flaherty

Chairman of the Board of Examiners

28 June 2005

Faculty of Actuaries
Institute of Actuaries
Subject ST2 (Life Insurance Specialist Technical) April 2005

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1 Premiums may be paid out of pre-tax personal income.
The government may grant additional amounts to effectively increase levels of
premiums paid into contracts.
Investment funds may receive favourable tax treatment.
The fund may pay nil/reduced tax on investment income and on realised investment
gains.
Any combination of the above would lead to higher investment returns overall.
Policy maturity proceeds may be received tax free
May have tax free incentive on surrender proceeds
Offering incentives to employers who contribute to savings products for employees
Some incentives may be subject to certain conditions (e.g. minimum term, only
regular premiums, minimum period for investment for surrender incentives)
Taxation of life insurance companies may make them more attractive as a savings
medium than contracts offered by other savings institutions which may be subject to a
different fiscal regime
This question was standard bookwork and was answered well by most candidates.
However, in many cases insufficient detail was given to gain full marks.
2 The company would have defined aims for calculating policy alterations, and
may wish to ensure policy alterations can be simply administered and
calculated.
Some insurers may want the alteration to be profit neutral such that the same
profit is expected from the contract after the alteration to that expected before
the alteration. The terms may therefore be likely to be set so the reserve and
surrender value for the contract after the alteration should be the same as
before the alteration. Alternatively it may want the expected profit after the
alteration to equal the expected amount had the policy originally been written
on its altered terms.
Any increase in benefit may be subject to additional evidence of health. The
choice may depend in part on the scale of the alteration and when it occurs in
the policies lifetime.
The company would also want to cover costs associated with performing the
alteration
The company would want the altered terms to appear reasonable to
policyholders and the company would also want to ensure consistency with
Subject ST2 (Life Insurance Specialist Technical) April 2005

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benefits given to other customers. It would therefore want small alterations in
premiums to lead to small changes in benefits (and vice versa)
Large increases in premiums or benefits would therefore be expected to give
changes consistent with terms available on new business. Terms would also
ideally be consistent with those for paid up and surrendered policies
Ensuring terms are similar to current premium rates would also be desirable in
order to avoid lapse and re-entry
It was surprising how poorly some candidates answered this question. Many
candidates failed to discuss profitability, in particular the different approaches
insurers might take with regard to the profitability of the altered contract.
3 The normal premium payable for the whole of life policy being issued now:
P
basic
= 20,000 A
[50]
/
[50]
= 20,000 0.32868/17.454 = 376.62
The premium payable for the policy taken out under the option, from the age
of 60, would be
P
option
= 20,000 A
[60]
/
[60]
= 20,000 0.45510/14.167 = 642.48
The expected present value of the cost of providing the option is the expected
present value of the benefits less the expected present value of the premiums
EPV(benefits) = 20,000
1
[50]:10
A
+{ D
60
/ D
[50]
}
{0.7 * 20,000 * A
60
+ 0.3 * 40,000 *
60
} A

This is because after ten years 30% have 40,000 benefit and are subject to a
higher mortality, indicated by the primed functions.
The mortality assumed for those not taking up the option is AM92 ult.
Evaluating
1
[50]:10
A = {M
[50]

M
60
}/ D
[50]
= {448.91 402.93}/1365.77 = 0.033666
D
60
/ D
[50]
= 882.85/1365.77 = 0.64641
A
60
= 0.45640
60
A = A
70
= 0.60097
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EPV(benefits) = 20,000 * 0.033666
+ 0.64641 * {0.7 * 20,000 * 0.45640
+ 0.3 * 40,000 * 0.60097}
= 673.32 + 8,791.98
= 9,465.30
The present value of premiums (excluding the extra premium) is
EPV(premiums) = 376.62
[50]:10
+
{D
60
/ D
[50]
}
{0.7 * 376.62 *
60
+ 0.3 * (376.62+642.48) *
60
}

= 376.62 * 8.318 + 0.64641 * {0.7 * 376.62
* 14.134 + 0.3 * 1019.1 * 10.375}
= 3,132.73 + 4,459.03
= 7,591.76
[50]:10
=
[50]
{D
60
/ D
[50]
}
60
= 17.454 0.64641 * 14.134 = 8.318
60


=
70
10.375
The expected present value of the additional cost of the option is therefore:
9,465.30 7,591.76 = 1,873.54
This must equal the expected present value of the extra premium to cover the
option cost, so:
P
extra
*
[50]:10
= 1,873.54
P
extra
= 1,873.54 /
[50]:10
= 1,873.54/8.318 = 225.24
This question was standard bookwork and was answered well by most candidates.
4 Data checks will be made on the quality of data this will help identify issues
with data which could invalidate the valuations/projections of the company
Solvency a valuation of the company is made at least once a year. This assesses
the ability of the company to meets its liabilities when due.
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Sensitivity tests will be used to test the ability for the valuation to withstand changes
in experience
Investigations into the profitability of new business, including sensitivity analyses,
will help assess impact of changes in new business mix and volumes.
Investigations will be made into the appropriate asset mix and investment policy,
including stochastic modelling to test different investment conditions consideration
of the extreme values can help identify what circumstance will cause the company
problems and enable management actions/strategy to be formulated
Experience experience investigations will be carried out to confirm how the bases
underlying the valuations compare to experience
Analysis of surplus this will be further confirmed by any analysis of earning or
surplus
These investigations will determine whether and how discretionary policy charges
need to be amended and whether products need to be redesigned.
Analyses of expenses could validate assumptions used, and assess the extent of any
mismatching of expenses and charges
Analysis of persistency will help management decide whether surrender / termination
scales need review, and any customer retention activities need to be reviewed.
Changes in mortality experience could indicate changes in underwriting and claims
management may be required. Separate investigations into the underwriting process
and controls may be required
Distributions of surplus a bonus investigation (including investigations into asset
shares) will be undertaken to make sure that the company does not over-distribute
bonuses, and treats customers fairly / meet PRE
Investigations into guarantees and options available, and stochastic modelling, will
help assess the company s ability to withstand adverse economic conditions and
assess the capital required.
Projections of solvency/ earnings, including the ability of the company to pay
dividends, will help identify under what circumstances the company may need capital,
and how much.
Projections of forecast new business and existing business will help assess capital
requirements.
Investigations into the investment performance will monitor performance of asset
managers
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The reinsurance strategy will be reviewed, including retention limits and financing
requirements, to check that the company s exposures are within the company s risk
appetite.
Investigations into complaints will identify TCF issues and help with setting
appropriate misselling reserves

these will help manage risks in the sales area,
reducing the risk and impact of future litigation
This question was poorly answered by many candidates. Whilst candidates mentioned a
number of investigations, in many cases there was no explanation regarding why such an
investigation would be made and what risk it was designed to manage. Saying so that
management can take action did not show sufficient understanding to gain marks.
5 (i) The amount of the reserves should be calculated by a suitably prudent
actuarial valuation of all future liabilities, including options and guarantees,
for all existing policies.
Where no explicit allowance is made for future bonuses, the valuation rate of
interest should be reduced
The rate of interest used in the calculation of the reserves should be chosen,
taking into account the currency in which the policy is denominated, and
having regard to the yields on corresponding existing assets and to the yield
which it is expected will be obtained on sums invested in the future
The elements of the statistical basis (demographic, withdrawal) should be
chosen taking into account the type of insurance, country where insured
people live
The valuation should take account of the nature, term and method of valuation
of the corresponding assets
The method of calculation of the reserves from year to year should be such as
to recognise profit in an appropriate way over duration of each policy, and
should not be subject to discontinuities arising from arbitrary changes to
valuation basis
Each life insurance company should disclose the methods and bases used in
the valuation
If valuation method defines expense to be used in the valuation, the amount
should not be less than prudent estimate of relevant future administration and
commission costs
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(ii) Suitably prudent method
The Net Premium method is suitably prudent because:

guaranteed benefits are valued directly by the net premium method

bonuses which have already been guaranteed, whether described as vested,
declared or allotted are valued directly

options: the net premium method would not allow for the cost of options
and so an additional reserve would be needed
Future premiums: the method takes credit for future premiums by valuing the
net premium.
Future Bonuses
Allowance is made for future bonuses through a reduction to the valuation rate
of interest.
The difference between the office and net premium may also includes a
margin for future bonuses, although this margin would usually be used as an
allowance for future expenses.
Terminal bonus is not reserved for explicitly. However, the method is used
with a book value of assets, so that investment appreciation is taken to an
investment reserve, and not brought into the comparison between assets and
liabilities when surplus is determined.
Expenses and Commission
The margin between the office and net premium allows for future expenses.
A Zillmer adjustment may be used to allow for initial expenses. Though being
implicit, this may not be adequate, in which case an additional reserve would
be held, or the net premium restricted to a maximum % of the office premium.
Statistical Basis
The mortality used in the valuation is set prudently, by reference to current
and expected future experience.
Interest rate
The valuation interest rate used in the Net premium method is related to the
yield on the assets.
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Recognition of Profit
The method produces a smooth emergence of profits, if used in conjunction
with assets taken at book value.
Disclosure
The net premium method and basis are simple to describe for disclosure
purposes.
(iii) The impact of a decrease in the value of assets on the valuation basis depends
on the mix of assets and how much of the fall in assets is absorbed by the free
estate. If the decrease in value of assets is primarily in the value of equity
investments then this would be absorbed by a reduction in the investment
reserve and would have little impact on the liabilities
If the decrease were accompanied by an increase in interest rates this would
decrease the value of the liabilities because the valuation interest would also
rise. However, this would not necessarily mean that the value of liabilities
would decrease by the same amount as the assets because:

the assets and liabilities are unlikely to be matched

the valuation interest rate change also changes the amount of the net
premiums meaning that the liabilities are less sensitive than assets of a
similar term

any changes to the implicit allowance for future bonus will have an impact

the increase in the valuation rate may be limited by any restrictions in the
maximum reinvestment rate allowed
The impact of the change in net premiums would be impacted by any
restrictions on the net premium as a proportion of office premium
Parts (i) and (ii) were generally well answered. Part (iii) was poorly answered with a general
lack of reasoning given in solutions.
6 The company will have to decide whether to offer just one of the charging structure
options, or whether to offer both as alternatives.
Profit Testing
For each chosen version, it will have to perform profit testing to determine what level
of charges will be sufficient to cover its expenses and provide a profit margin in line
with target requirement.
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If the result of these tests is that a charge which is acceptable to the insurance
company exceeds x% and/or y%, then it may have to accept that one or both is not a
viable option.
Assumptions
In order to perform profit testing, the company will have to make assumptions
regarding future experience, particularly the level of future premiums and persistency.
The company will have to consider the fact that past persistency experience might not
be relevant to the new charging structure. For example, the absence of explicit
surrender penalties and the standardisation of charging structures means that
employers might transfer their policies more readily.
Persistency and premium level experience might also differ between version (a) and
version (b) of the charging structure.
Selection
As two charging structures will be available, employers could select against
providers. For example, if they do not expect to be paying significant levels of future
premium then they might be more likely to opt for a version (b) product. If they
expect the term of investment of each premium to be relatively short, then they might
be more likely to opt for version (a).
If the company offers both versions of the product, in order to reduce the impact of
anti-selection it will have to decide whether it should introduce restrictions regarding
the extent to which employers can switch between the two versions. However, such a
restriction could reduce the attractiveness of the product to the market.
It might not be permissible under the new regulations.
It might also encourage employers simply to switch to other providers.
Market/Competition
The company should monitor what competitors are intending to offer, and set charge
levels which are not out of line with these other products.
As the charging structure is so transparent, these products are likely to be purchased
primarily on price. Hence the charges should be set as low as possible (whilst
maintaining an adequate contribution to profit).
The company needs to evaluate the optimal pricing strategy by taking into account the
interaction between margin and volumes.
The company should consider the size of the potential market and whether there is
sufficient market demand for the product
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If the target profit requirement is not met, the company will have to decide whether to
offer either option for commercial reasons, despite the fact that it does not meet profit
criteria
Expenses/Charges
The company should consider the financing requirement of each design. This should
be in light of the level of its free assets and capital available (e.g. the use of financial
reinsurance) . The better matched the charges and expenses, the lower the risk. This
should therefore reduce the capital requirement (depending on the nature of the
regulatory environment).
Charges expressed as a proportion of premiums might be expected to increase broadly
in line with maintenance expenses, if the premiums paid are based on a percentage of
salaries. Charges expressed as a proportion of funds under investment might be
expected to increase at a rate in excess of expense inflation, but better match
investment fees charged as a proportion of funds under management.
The insurance company will have to decide whether or not to make the charges fixed
or variable up to the given maximum. Fixed charges might be more attractive to the
market, but this would increase the risk to the insurance company and therefore is
likely also to increase the capital requirement (depending on the regulatory
environment).
The insurance company will have to consider what form and level of commission it
should pay to the insurance intermediaries. For example, under version (a) it might
prefer to offer fund based renewal commission, but premium based commission under
(b), as this better matches the charging structure.
The company should consider whether other distribution channels may be more
appropriate
Sensitivity
The company should test the sensitivity of profit to variations in future experience.
For example, version (a) will be sensitive to future investment returns, and if x < y
then version (a) will also be more sensitive to early withdrawal experience.
Since both options will result in a cross-subsidy from large to small policies, the
company should consider whether to impose a minimum case size.
Administration/Cross Subsidies
It should also take into account any limitations on product design as a result of its
administration systems. If its existing products are similar to one or both of the
proposed charging structures, then this will facilitate development.
Treating customers fairly
The company must consider TCF issues when deciding product design
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This question was generally not answered very well. Most candidates failed to address a
number of key issues and did not use the information given in the question. Some candidates
did not seem to realise that the regulator had set a maximum charge and went on to discuss
how the charge could be increased. Candidates often failed to compare and contrast the
different designs of contracts, in particular the different risks the designs left them exposed
to. There was also a general lack of understanding of group endowment contracts.
7 (i) The principles of investment are that an insurance company should select
investments that are appropriate to the nature, term and currency of its
liabilities.
The investments should also be selected so as to maximise the overall return
on the assets, where the overall return includes both income and capital, and
the extent to which the company may depart from investing in appropriate
investments in order to match its liabilities, depends amongst other things on
the extent of the company s free assets.
These investment principles can also be expressed as:
The life insurance company should invest so as to maximise the overall return
on the assets, subject to the risks being taken on being within the financial
resources available to it.
(ii) Unitised with profits single premiumcontract with a termof 10 years, a
guaranteed death benefit of the initial premium+ 2% per annum
compound, and return of fund (premium+ bonuses) on maturity.
On death during the 10 year term the policyholder receives a guaranteed
amount of the initial premium plus 2% per annum compound. The company
will ideally want to invest so that it has sufficient assets at any time during the
term to meet this guaranteed amount. Therefore the company will want to
invest in assets that produce a flow of asset proceeds that match the expected
liability outgo.
The expected liability outgo each year will be the guaranteed death benefit
multiplied by the probability of the death benefit being payable in that year.
The company may choose to invest in fixed interest securities to match the
expected liability outgo. However the extent to which the insurer needs to do
this will depend on the value of the death benefit versus the value of the unit
fund under the contract during the term. This could be identified using
stochastic modelling, and a portfolio of suitable, more secure assets, could be
identified to reduce the likelihood of shortfalls in the future
On maturity the policyholder receives a return of fund (premium + bonuses)
from the unitised with profits fund. Usually insurers want to maximise the
returns that policyholders achieve by investing in their with profits funds and
the policyholder will at least usually want to earn a real rate of investment
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return throughout the term of the policy. Hence the insurer will invest in
assets that are likely to produce the best real rate of return for the unitised with
profits fund. This may lead the insurer to invest in equities rather than fixed
interest securities, if equities are likely to offer the best real rate of return over
the term of the contract.
Exposure to equity markets could be achieved through the use of financial
instruments
The insurer may choose to invest in other assets producing real rates of return
(e.g. property or overseas equities) to provide diversification
During the term of the contract, it is likely that the insurer will grant regular
bonuses (either through an increase in the price of units in the with profits
fund or by allocating additional units to a policyholder). These bonuses once
granted form part of the guaranteed benefits that the policyholder will receive
on maturity. Hence during the term of the contract the guaranteed benefits
will increase and the insurer will want to invest in assets that match these
guaranteed benefits by investing a greater proportion of the assets backing the
contract in fixed interest securities. However if guaranteed benefits increase at
a lower rate than that earned on the underlying assets then the proportion of
assets held in fixed interest securities may not increase.
In some countries there will be regulations governing what assets the insurer
can invest in (e.g. 50% of unitised with profits funds in government securities.
There may also be a requirement to produce a guide for policyholders
explaining the investment strategy for the unitised with profits fund.
There will be a need to follow any strategy disclosed in marketing literature
The insurer will have administration expenses throughout the term of the
contract. These will be real in nature (e.g. since the salary costs of an
insurance company are real in nature) and hence this expense liability should
be matched by assets offering a real rate of return. In practice this is likely to
be taken into account through the investing of some of the assets backing these
contracts in real assets such as index linked securities.
We are told that the insurance company has a deteriorating solvency position.
In practice this is likely to mean that it will take a more conservative view and
will want to be more certain of having sufficient asset proceeds to meet the
guaranteed death benefit than might otherwise be the case.
This is likely to mean that the insurer invests relatively more in fixed interest
securities and corporate bonds than more volatile investments such as equities,
to protect its solvency position.
The insurer may assess appropriateness or otherwise of investment strategies
by using dynamic solvency testing and assessing the probability of ruin
The company will need to take into account its taxation position
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(iii) A fixed annuity contract paying a fixed amount each month to an
annuitant until their death, plus 5*annual annuity payment minus
payments made on death in first five years.
Under this contract most of the future liability outgo is fixed in nature and
therefore the majority of the assets backing this contract will be invested in
fixed interest securities, where the asset proceeds from the portfolio of fixed
interest securities match the expected fixed liability outgo. The assets held will
be in the same currencies as the liabilities.
However, the liability outgo is likely to have a very long discounted mean
term and it may not be possible for the insurance company to match the
expected fixed liability outgo by investing in fixed interest securities, since
there may not be sufficient fixed interest securities availably with a
sufficiently long term. In this case the insurer will use immunisation
techniques to select a portfolio of fixed interest securities (or financial
instruments/credit derivatives) that provide the best match possible to the
expected liability outgo.
Immediate annuities are very competitively priced in some markets and hence
it may be that the margins for profitability are very tight within this contract.
To improve the potential returns therefore, the insurer may choose to invest in
assets that are expected to provide a slightly higher rate of return over the
duration of the investment than can be achieved from investing purely in
government backed fixed interest securities. This may mean investing in a
variety of high quality corporate bonds (e.g. by investing in corporate bonds
where the companies are of appropriate credit ratings) if they are available in
the market place.
Corporate bonds usually offer a slightly higher rate of return than government
bonds but are not as risky as investing in equities, but need to take into
account the views of investment managers on corporate bonds
Care would be taken to keep to high grade bonds where some extra yield can
be obtained from accepting liquidity risk but limiting the exposure to credit
risk. This may lead the insurer to stick to investment in safer government
securities (if this is the case), since the insurer cannot take on the risk of an
issuer of corporate debt defaulting for the additional return provided. The
extent to which the insurer will choose to do this will be influenced by the fact
that the solvency position for the insurer has worsened in recent years.
The expenses of administering the contract will be real in nature, hence it may
be appropriate to invest a small proportion of the assets backing the contract in
index linked securities if they are available or equities.
For each tranche of annuity business written, a small number of annuitants
will die within the first 5 years of the contract (this can be calculated through
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reference to the appropriate annuitant mortality tables), resulting in an
accelerated payment for these annuitants.
This can be allowed for in the calculation of the expected liability outgo (and
will have the impact of decreasing the discounted mean term of the liabilities
overall) and hence will impact the portfolio of fixed interest securities chosen
to match the expected liability outgo.
Part (i) was well answered. In part (ii) many candidates did not seem to appreciate the
difference between a unitised with-profit contract and a unit linked contract, and hence failed
to pick up many of the marks available. Part (iii), whilst being relatively standard bookwork,
was poorly answered. In both parts (ii) and (iii) most candidates did not mention the
deteriorating solvency position of the company and the impact that has on investment policy.
8 (i) There are no special charges that need to be taken to support the surrender or
maturity or death benefits.
This means that the annual management charges from the two types of units
and the bid offer spreads are required to meet the expenses, cost of capital and
profit required by the company.
Depending on the size of the annual management charge on the capital units,
the charges will start at quite a low level, and then grow each year as the fund
increases.
In addition, a fixed percentage of the premium will be received via the bid
offer spread.
The main expenses are:

commission

claims/termination costs

sales and marketing related expenses

initial policy set up costs

renewal policy costs

investment costs
Initial commission will be large, premium related and at the start of the policy.
If the company pays fund related commission then this could be matched by
fund management charges
The claims and termination costs are likely to be small, but are not matched by
any specific charges
Subject ST2 (Life Insurance Specialist Technical) April 2005

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The sales and marketing costs will be probably expressed as a premium related
cost that will also be at the start of the policy.
The Initial set up costs will normally be expressed as a per policy cost at the
start of the policy.
The charges collected at the start of the policy will be much too small to cover
these costs.
On early surrender these costs will not be recouped
The renewal expenses will be expressed as a per policy cost and will be
incurred each year.
The annual management charges do not perfectly match the renewal expense
as the charge is a percentage of fund and premium not a fixed fee. However,
the charges are likely to more than cover this expense.
The investment expense is likely to be expressed as a percentage of the fund
each year.
The annual management charge matches the expense well as both are a
percentage of the fund. It is unlikely that the investment costs will not be
covered by these charges.
In total, the charges do not well match the expenses in timing.
The charges will more than cover the renewal and investment expenses, but
the excess will be required to repay the other costs incurred at the start of the
policy.
And to cover the cost of the capital used to cover that strain until it is repaid.
The annual management charges, being a percentage of fund, leaves the
company exposed to stock market fluctuations. This is particularly so in later
years when the majority of the charges will be in this form.
The charging structure may well meet the company s profit criteria, but it is
not very capital efficient and so is only viable if the company has access to
plenty of capital.
Fixed and overhead costs are not explicitly covered by any policy charge
(ii) It is common for companies to anticipate the extra future annual management
charges associated with the capital units by actuarial funding.
It is usual to hold unit funds that exactly match the bid value of units
purchased.
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However, the full value is only needed at maturity or death.
It is therefore reasonable to hold the actuarial present value of the unit fund
rather than the fully funded value.
If UF
t
is the fully funded number of units purchased at time t, then the amount
needed to be held is
UF
t
A
x+t:10 t
If the discount rate is less than or equal to the extra management charge, then
the fund will be able to meet its obligation to the policyholder.
Clearly the maximum amount of actuarial funding is achieved if the full
amount of the extra annual management charge is used as the discount rate.
This releases capital at the point the capital units are purchased.
As the capital units are purchased in the first two years, this releases capital at
the time when it is most needed.
It also converts the charge from a unit related one to cash, removing a large
amount of the risk from stock market movements.
The only problem is that it means that the company can no longer pay out bid
value of units on surrender, as it does not hold sufficient units.
It needs to introduce a surrender penalty that brings the terms offered to the
policy holder in line with the actual units held.
This will be in the form of a unit penalty, decreasing as the duration to
maturity decreases.
(iii) If all else is equal, the revised design incorporating actuarial funding will
require a smaller additional annual management charge than before.
This is for two main reasons. Firstly, as the new business strain is paid back
faster, the cost of tying up the capital is smaller. Secondly, there is less paid to
surrendering policyholders
As the annual management charge is smaller the maturity benefits will be
higher.
Those policyholders that surrender early in the term will receive less.
However, those that surrender late in the term may well receive more as the
lower management charge may more than compensate for the surrender
penalty.
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The death benefit paid is the bid value of units and hence the change will be as
for maturity benefits.
In general this question was relatively well answered. In part (i) the better candidates listed
the different types of expenses and gained marks by discussing the basic properties of the
charges and expenses of the product. Parts (ii) and (iii) were well answered.
END OF EXAMINERS REPORT
Faculty of Actuaries Institute of Actuaries
EXAMINATION
8 September 2005 (pm)
Subject ST2 Life Insurance
Specialist Technical
Time allowed: Three hours
INSTRUCTIONS TO THE CANDIDATE
1. Enter all the candidate and examination details as requested on the front of your answer
booklet.
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 the
supervisor.
4. Mark allocations are shown in brackets.
5. Attempt all 7 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 this
question paper.
In addition to this paper you should have available the 2002 edition of the
Formulae and Tables and your own electronic calculator.

Faculty of Actuaries
ST2 S2005 Institute of Actuaries
ST2 S2005 2
1 A life insurance company has written individual term assurance business for many
years. In the past it has reinsured a very small proportion of this business.
(i) Describe why the life insurance company might have reinsured some of its
business. [4]
(ii) Describe why the life insurance company may look to reinsure a greater
proportion of its new term assurance business in the future. [7]
[Total 11]
2 A life insurance company writes only conventional without profits business.
(i) List the sources of risk for the in-force business. [4]
(ii) Explain how new business can be a source of risk. [8]
[Total 12]
3 (i) State the main requirements that an actuarial model should satisfy. [5]
A unit-linked single premium whole life policy allocates 101% of the
premium into units. The policy can be surrendered at any time and the
policyholder will receive the bid value of units held at that time. However, on
the tenth policy anniversary, the policyholder will receive the higher of the bid
value of units and the original premium. The only charge under the policy is
an annual management charge. A deterministic cashflow model is used to
determine an appropriate level for the annual management charge.
(ii) Explain why this model is unlikely to produce an appropriate charge for the
return of premium guarantee at the tenth anniversary. [5]
(iii) Explain why a stochastic model would be better than a deterministic model for
this purpose. [3]
[Total 13]
4 A life insurance company in an economically developed country has a large in-force
portfolio of level immediate without profit annuities. It wishes to assess its liabilities
on a market consistent basis using a financial economic modelling approach.
(i) Describe a model that could be used to perform this calculation. [5]
(ii) Discuss how the assumptions used within the model might be determined. [9]
[Total 14]
ST2 S2005 3
5 A proprietary life insurance company has previously only sold unit-linked policies
and has limited free assets. It is about to launch a single premium with profits product
with a term of 10 years for which the majority of assets will be invested in equity-type
investments. Surplus will be distributed using the additions to benefits method
through a combination of reversionary and terminal bonus. The company will explain
its bonus distribution policy in its marketing literature.
Discuss the factors that the company should take into account when considering the
split between reversionary and terminal bonus. [14]
6 A life insurance company has a large portfolio of single premium whole life unit-
linked bonds. The single premium can be invested in any one of a range of available
linked funds.
The policy provides a death benefit equal to 101% of the bid value of units and a
surrender value of the bid value of units. There is an annual management charge of
between 0.75% and 1.5% per annum of the bid value of units depending on the fund
chosen. No other charges are made on the policy.
A policyholder may switch between funds at any time. The first switch in any year
can be made free of charge, and any further switches incur a charge which is linked to
inflation. Past experience has shown that on average policyholders switch more often
than once per annum.
The company is about to perform the calculation of its supervisory returns for this
product.
(i) Describe the principles that it should follow. [6]
(ii) Describe how the company would set the assumptions for this purpose. [10]
[Total 16]
7 A life insurance company last conducted a full analysis of its management expenses
five years ago, and since then has used this as the basis for setting expense
assumptions when calculating its supervisory reserves.
It is proposed that a new expense analysis will be carried out to help set assumptions
for use at the next statutory valuation.
(i) Describe how the analysis might be carried out. [15]
The Finance Director has queried the cost of carrying out a new expense analysis and
has proposed that the existing method of adjusting the old expense analysis by
inflation should continue to be applied.
(ii) Discuss the Finance Director s suggestion. [5]
[Total 20]
END OF PAPER
Faculty of Actuaries Institute of Actuaries
EXAMINATION
September 2005
Subject ST2 Life Insurance
Specialist Technical
EXAMINERS REPORT
Introduction
The attached subject report has been written by the Principal Examiner with the aim of
helping candidates. The questions and comments are based around Core Reading as the
interpretation of the syllabus to which the examiners are working. They have however
given credit for any alternative approach or interpretation which they consider to be
reasonable.
M Flaherty
Chairman of the Board of Examiners
29 November 2005
Faculty of Actuaries
Institute of Actuaries
Subject ST2 (Life Insurance Specialist Technical) September 2005

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1 (i) Why reinsure?
The company would want to reinsure some of its business:

to reduce its overall retention to limit the impact of any one claim on its
profits

to gain the reinsurer s help with risks it has limited experience of

to get assistance with underwriting substandard lives
Even though it has written term assurance business for many years, the life
insurer may not have written significant volumes of business and hence the
company may be concerned about claims fluctuations arising on a small book
of business.
It may want the reinsurer to review its underwriting procedures to ensure that
they are up to date and reflect the latest techniques being used by other
insurers in the market to evaluate individual risks.
The life insurance company may also want specific advice on how to allow for
particular risks that appear to be prevalent in its claims book.
However, the life insurer s desire to obtain technical advice from a reinsurer
will be limited by the knowledge that reinsuring business also usually involves
ceding part of the profits arising on a book of business to the reinsurer and
hence overall profitability may be reduced by ceding more of the business to
the reinsurer negating the life insurer s aim.
It may also want catastrophe cover to protect the solvency of the company
against extreme events.
In addition reinsurance may be taken out to help mitigate new business strain.
For example, by using financing reinsurance
The insurer may be able to take advantage of legislative advantages if the
reinsurer is offshore which may enable an arrangement to allow both
companies to enhance profits.
There may be tax advantages from taking out reinsurance.
(ii) Reinsure a greater proportion of its new term assurance business
The company may need to reinsure a greater proportion in order to get
additional data or other support from the reinsurer.
The insurer is particularly likely to seek the reinsurer s advice if its term
assurance rates have moved out of line with other providers in the market,
since the life insurer will want to understand how it can write the business on
competitive and profitable terms.
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This is particularly an issue given that the term assurance market is usually
very price sensitive/competitive and offers low levels of profit.
Recent claims experience may have deteriorated and the life insurance
company may want a reinsurer s advice on why this is.
It may equally be concerned about potential impacts to future experience from
for example the incidence of a new disease.
Alternatively it may require more reinsurance as its attitude to risk has
changed
The life insurance company s solvency position may have deteriorated
recently so that it needs to protect its solvency position more than it did in the
past from adverse claims experience.
The life insurance company may have recently been taken over by a larger
insurance group and it may be a requirement of that insurance group to cede a
larger proportion of business to a reinsurer to ensure that underwriting results
are smooth, with neither large profits nor losses arising on this line of
business.
Another reason may be that the nature of the business written has changed
It may be writing business in new markets for example Group business or in
overseas markets
It may have added new benefits to products, for example Critical Illness cover
For example the insurer may be using a new sales channel or targeting
business at a new consumer segment.
The life insurance company may be accepting larger individual case sizes, in
terms of sums assured, than was the case in the past and it may wish to pass a
greater proportion of these risks on to a reinsurer to protect it from large claim
fluctuations arising due to one or two large claims.
The volume of business may have increased such that the insurer needs more
help with financing new business strain
There may have been changes in local regulations that allow the company to
reduce the amount of solvency capital it is required to hold as a result of
reinsuring some of its business, encouraging it to reassure more.
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It may also be the case that the solvency or tax regulations have changed
which improve the attractiveness of reinsurance.
Finally, it may be that reinsurance rates have improved and reinsurance is now
cheaper and so more attractive.
2 (i) Accuracy of policy and other data
Variations in
Mortality experience
Underwriting standards not consistent with premium assumptions
Investment Performance
Expenses
Inflation
Withdrawals
New Business mix or volume
The cost of Guarantees and Options
Impact of actions of competition
Actions of staff and Directors (e.g. misselling)
Failure of systems and controls (including new business processing, claims
handling, policy servicing)
Counterparty failure (e.g. reinsurer, issuer of corporate bonds)
Liquidity of assets held
Legal, regulatory or fiscal changes
Fraud from employees, customers or intermediaries
Aggregation or concentration of risk
(ii) If too much business is sold there is likely to be a higher capital strain than
expected
This may lead to solvency problems
In addition too much business may lead to operational difficulties. The
customer service operation may not be able to cope with higher than expected
demands and this may lead to a reduction in service standards
This may lead to an increase in surrenders or policies not being taken up
which causes a loss in embedded value
It may also lead to bad publicity or strained relationships with distributors
which may adversely impact future sales and therefore profits
If too little business is sold then the lower income would not cover expenses
incurred as expected
This would lead to lower profitability than expected on business written as
more expenses would need to be spread over fewer policies
In addition variations in business mix may be a source of risk.
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Different products may have different levels of profitability. If the mix is
different to expected it is possible that the average profitability will be reduced
In addition the capital requirements will differ for different products. If a
higher proportion of capital intensive products are sold than expected then this
may lead to solvency problems
Changes in mix may also impact on the company s operations as it may not
have sufficient expertise to cope with growth in volumes of certain business
The mix of business within a particular product can also be a risk. For
example if average premium size is lower than expected this may lead to
lower profitability
There is also risk that business is lower quality than expected and surrenders
are higher than expected
This may be due to differences in the socio economic group of customers
This may also be due to problems with its underwriting
Similarly it may be due to differences in the mix by distributor.
There is also a risk that commission paid is not clawed back on surrender of
policies due to the practice of distributors
Actions of competitors may introduce risks through changes in their premiums
or charges influencing the volume or mix of business achieved.
In addition market movements may introduce risk to the profitability of new
business for some products, for example Annuities
3 (i) The requirements depend on the purpose for which the model would be used.
The model must be valid and fit for purpose.
It should be rigorous.
It should be well documented. (audit trail)
The model points must adequately reflect the distribution of the business being
modelled.
The parameters must allow for the features of the business that could
significantly affect the advice being given.
The inputs to the parameter values should be appropriate to the business being
modelled and take into account the special features of the company and the
business/economic environment in which it s operating.
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The outputs should be capable of independent verification for reasonability.
The output should be capable of being communicated to the recipients of the
advice.
The model should not be too complicated so that the results are too difficult to
interpret or communicate.
The model should not take to long or be too expensive to run.
Some level of controls and consistency checking should be built into the
model.
(ii) For the 10
th
anniversary guarantee to have a modelled cost there needs to be a
cash flow generated from the guarantee biting.
This will occur if the model produces a fund value at the 10
th
anniversary that
is lower than the original premium
The deterministic model will project forward the fund position based on an
expected level of investment returns
With this policy the fund value starts at a level greater than the premium.
The fund value then grows at the expected rate that is consistent with the
assets backing the unit funds.
This is likely to exceed any fund decreases each month as the charge is
deducted, but any commercial charge is likely to be lower than the rise in asset
values.
This means that the fund will rise overall.
As a result the fund value at the 10
th
anniversary will be higher than the
original premium and so there will be no cash flow generated as a result of the
guarantee.
The cost of the guarantee as derived by the models will therefore be zero
However, in reality there is a risk that investment values will fall over the ten
year period and the fund at the 10
th
anniversary is lower than the guarantee
level
In such cases the company would have to pay the shortfall to any policyholder
who surrenders.
The cost derived by the deterministic model is therefore clearly inappropriate
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(iii) A stochastic model runs many different investment scenarios, where the future
investment returns are governed by a probability distribution function.
Some of those investment scenarios will show poor investment performance,
where the fund value falls below the original premium level.
In these scenarios the cost of the money back guarantee will result in a
negative cash flow to the company.
The company would run many simulations and the cost of the guarantee
determined by the model will be the average shortfall over all simulations
As a result, the company will recognise the need to charge a higher annual
management charge for offering the guarantee
The stochastic model is clearly superior in that it can correctly determine the
need for such a charge
4 (i) The model will show projections of future cashflows arising on this portfolio
of business.
The key cashflows will be annuity payments and expenses.
The projected cashflows must be discounted at an appropriate investment
return in order to value them on a market consistent basis.
The projections may be performed on individual policy data.
However, since the portfolio is large, the company may instead decide to use
data grouped into model points.
Data grouping would introduce an additional level of approximation. The
decision as to whether to use grouped or individual data is likely to depend
upon the purpose of the calculation, and therefore the required degree of
accuracy.
The same consideration applies to the choice of projection period frequency,
e.g. whether to use monthly or annual cashflows.
Given the relative simplicity of the cashflows in this case, the company is
likely to choose a deterministic projection approach.
An alternative approach would be for the company to use a stochastic model,
introducing variability into any or all of the investment return, inflation or
mortality assumptions.
(ii) Assumptions will be required for mortality, expenses, expense inflation and
investment return.
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There is unlikely to be a highly liquid active market for mortality risk, so it is
not possible to determine a unique and objective market consistent mortality
assumption.
Instead, the mortality assumption is likely to be set by reference to industry
statistics, internal experience investigations and information from reassurers.
The assumption should include appropriate allowance for future mortality
improvements.
The expense assumption might be determined by reference to expense
agreements available in the market, for example from third party
administration companies, as well as from industry statistics and features
specific to the company s own experience.
If the liabilities or cashflows were to be traded in an open market, then
potential purchasers might require a margin to reflect the risk that mortality
and expense assumptions prove to be incorrect.
The future annuity payments are known amounts, after allowing for mortality
as assumed. They are therefore equivalent to the maturity proceeds of a series
of zero coupon bonds of matching terms.
The appropriate discount rate in order to obtain a market consistent valuation
is therefore the market yield on such bonds.
These yields are likely to vary by term.
The payments are for guaranteed amounts, and hence the yields should be
risk free .
The country in which this company operates is highly developed, which
suggests that its government fixed interest bond issues might be close to risk
free .
The yield on these bonds can therefore be used as a proxy for risk free
yields, although it might be necessary to make adjustments if there are specific
market issues such as supply and demand mismatches.
Similarly, the expected expense cashflows might be valued by discounting at
the yields available on index-linked government bonds.
However it may be appropriate to adjust these yields if expense inflation is
expected to differ from the index inflation.
Alternatively the expense cashflows could include inflation, and these would
then be discounted at the normal risk free yield. The inflation assumption
would be set by reference to a comparison of market yields on index-linked
and fixed government bonds, adjusted if necessary as above.
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5 Maturity Payouts
Once reversionary bonus is declared it must be paid on death or maturity
Higher levels of reversionary bonus therefore increase the guarantees under a policy
Since the company will invest a significant proportion of assets in equities, which
have a volatile return, the underlying asset share is likely to be volatile
This is particularly true for a single premium policy
A high level of reversionary bonus will therefore increase the risk that, at maturity,
the guaranteed benefits might exceed asset share
If investment values fall, the company would therefore be exposed to having to pay
more than asset share, with a consequent reduction in its free assets
The company could charge for the guarantees or pay less than asset shares at other
times to meet the cost over time but this does not remove the short term risk
This could be a particular problem for this company since it has limited free assets
The risk is particularly great if the business is sold in tranches since a large proportion
of the business will mature on the same date so the company will be very exposed to
market conditions on that date
The amount of terminal bonus is determined when the insured event occurs and is not
guaranteed in advance. Having a high proportion of benefits paid in the form of
terminal bonus is therefore consistent with investing a high proportion of assets in
equities since, in theory, terminal bonus can be reduced to match any fall in asset
share
In practice, policyholder reasonable expectations, arising from marketing literature
may limit the extent to which terminal bonus can be reduced but it is still more
flexible than reversionary bonus
Reserves
It is normal for reversionary bonus to form part of the supervisory reserves, but for no
reserve to be held for terminal bonus. This means that a higher proportion of
reversionary bonus will increase the statutory reserves that the company needs to hold
These reserves are unlikely to be sensitive to changes in the market value of the assets
held
Since the company invests a significant proportion in volatile assets, this could
significantly increase the statutory reserves and reduce the free assets of the company
Again, this could be a problem for this company since it has limited free assets
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General
So, for a company with limited free assets that intends to invest a significant
proportion in equities, low reversionary bonus and high terminal bonus appears
appropriate
However, the company also needs to consider competitive pressures. If most
companies have a high reversionary bonus then this might be a requirement in order
to generate sufficient sales to justify launching the product
The company should also consider the target market and its requirements. It may be a
certain level of guarantees are expected or there are levels of smoothing that are
desirable
Since it is a proprietary company, the needs of shareholders would be considered.
Shareholders may prefer bonus to be paid sooner
In addition shareholders may benefit from a higher distributions if paid through
reversionary bonus if based on a share of total surplus on a strong reserving basis
Shareholders may be willing to inject more capital into the company to allow higher
reversionary bonus as long as the return generated on this capital for these
shareholders is high enough
Finally the company would need to consider what access it had to alternative sources
of capital which may mitigate the risk of having to draw down further capital from
shareholders
6 (i) Principles:
Reserves should be sufficient to ensure liabilities can be met as they fall due.
Reserves should be calculated for both unit and non unit reserves.
Reserves should include suitable valuation of all liabilities including

allowing for any options available to policyholder

allowing for any guaranteed benefits

expenses with allowance for inflation and allowing for closure to new
business if higher

allowance for an appropriate margin for adverse deviation of relevant
factors

suitably prudent assumptions
The method of calculation should be such as to recognise profit in an
appropriate way over duration of policy.
It should not be subject to discontinuities arising from arbitrary changes in
basis.
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Reserves calculated should also be set to avoid future valuation strain.
(ii) Assumptions
Mortality
Not key assumption,
but required to value additional death benefit over unit reserve
Based on recent mortality experience of life office or use industry
experience
Expenses
Renewal expense expected expenses to be incurred in admin of product
Assumptions would be set prudently based on analysis of recent
experience
Allow for the inflation since recent experience
Termination expense on claim, although this may be included in the
general renewal expenses
Allow for the impact of surrenders if this increases reserves
Switch expenses
Expense of switch
Number of switches per annum based on recent experience
Investment Expenses
Average annual management charge probably based on current
funds under management.
Investment expenses/charges incurred use recent experience or
known
Renewal commission allow for as paid
Rate of interest used for discounting non unit cashflows
Based on assets used to back sterling reserves.
Not a critical assumption given sterling reserves are likely to be small
Unit growth rate
Linked to rate of interest potential to depend on current fund
Needs to be set prudently
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Inflation
Used for inflating expenses and switch charge.
Given a large proportion of expenses are likely to be salary related then a
salary inflation rate may be appropriate for renewal expenses
Tax
Net down assumptions for tax using rates as paid
Consistency
Assumptions need to be consistent with each other
For example valuation rate of interest and unit growth assumption
7 (i) Expense Analysis
Need to agree period to which expense analysis will relate.
The company would use data from its recent expense analysis
Need to subdivide data into:
Direct expenses: Expenses that depend on volume of NB or level of in force
Overheads: Balance of expenses e.g. those that relate to general mgt and
service depts not directly involved in NB or policy servicing
Expenses of company can be split into cells :

whole business of life company

whole business of a particular accounting fund

each main product line of the company
These could be further subdivided into regular and single premium business,
paid up policies etc
In addition would want to split expenses into initial, renewal, termination and
investment expenses
Need to ensure that cells are not too small otherwise analysis will become
unreliable.
The main costs are Salary and Salary related
Expenses would be split by department/function.
Identify those departments that are directly involved in servicing policies, and
those that are overheads
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Those departments that are obviously linked to a particular product can be
allocated to that product line Life Servicing.
Would need to split time by process undertaken e.g. policy servicing,
policy set up or claim settlement
Where a function works on a variety of processes/products then the expenses
can be split using a timesheet analysis
Those departments that are identified as pure overheads (e.g. HR, Legal,
Accounting, Actuarial Valuation) can be split pragmatically across other
departments
e.g. HR could be split in proportion to number of staff in each direct area.
Property Costs
Property costs that relate to buildings occupied by the life company can be
split by floor space occupied across all departments, and then expenses
allocated as per salaries above
Computer Costs
Allocate to departments by computer usage
Costs of purchasing new computers could be amortised over useful lifetime
and then added to ongoing computer costs
Investment Costs
Directly allocated to investment expenses
Split directly by product line based on funds under management
One off capital costs
Amortise over expected useful lifetime and treat as part of overheads and
spread by department
Items that are treated as an asset of long term fund will not be amortised.
Instead there will be a charge (e.g. notional rent) made to departments and
allocated as per salary expenses
Exceptional Items that are unlikely to recur will be excluded from the analysis
Having split all expenses of the company will be able to come up with total
expenses by product line and within product line the expenses will be split into
initial, renewal, termination and investment expenses.
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Expenses would need to be inflated from the period of investigation to the
period for which they will be used
They may also be adjusted for any known changes in expense levels, eg
benefits from recent cost saving programmes
These would then need to be converted into allowances per policy using:
Average number of policies in force over analysis period (for renewal
expenses)
The number of new business policies may not be relevant for statutory
valuations.
However if zillmerisation of initial expenses was being used then assumptions
would be needed.
Average number of claims over analysis period (for termination expenses)
Investment expenses are likely to be expressed as a percentage of funds under
management so that they can be treated as a deduction from earned investment
return.
(ii) Finance Director s suggestion
There is some merit in the suggestion as the costs involved would indeed be
less
If the business written and processes involved have not changed much in five
years then the old analysis may be appropriate
However, a recent expense analysis can be used for many other purposes
e.g. pricing assumptions to ensure future business is profitable or assessing the
economic value of the company.
Over five years it is likely there have been changes since the previous
investigation that may invalidate it

Business mix may have changed, thus overheads need to be split in a different
way
Technology improvements may mean less costs involved in servicing
New products may have been introduced that require different types of
expense (underwriting, claim handling expenses)
Need to clarify if inflation increase is appropriate for the company expenses
Analysis of surplus and profit may not be valid if expense assumptions do not
closely reflect actual expenses
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Performing a more accurate expense analysis may allow reserves to be
released. These may have been caused by past margins in expense or inflation
assumptions which were deemed necessary due to lack of confidence in the
data.
In addition there is a need to consider professional guidance and legislation
which may require the company to have recent analysis for calculating
supervisory returns.
END OF EXAMINERS

REPORT
Faculty of Actuaries Institute of Actuaries
EXAMINATION
4 April 2006 (pm)
Subject ST2 Life Insurance
Specialist Technical
Time allowed: Three hours
INSTRUCTIONS TO THE CANDIDATE
1. Enter all the candidate and examination details as requested on the front of your answer
booklet.
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 the
supervisor.
4. Mark allocations are shown in brackets.
5. Attempt all 7 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 this
question paper.
In addition to this paper you should have available the 2002 edition of the
Formulae and Tables and your own electronic calculator.

Faculty of Actuaries
ST2 A2006 Institute of Actuaries
ST2 A2006 2
1 A life insurance company offers a minimum maturity guarantee on its regular
premium unit-linked savings contract. Describe how the company would determine
the charges to be taken for providing this guarantee using simulation techniques.
[5]
2 A life insurance company sells without profits non-linked whole life policies.
(i) Discuss why a surrender value might be offered on this type of policy. [4]
(ii) A recent survey has shown that the surrender values offered by the company
are lower than those offered by other companies. A customer service manager
has suggested that the company should increase surrender values so as to
avoid bad publicity.
Discuss this suggestion. [6]
[Total 10]
3 A life insurance company sells regular premium unit-linked endowment assurance
policies each with a term of 10 years. Currently, part of the first year s premium and
the whole of all other premiums are invested into accumulation units that have an
annual management charge of 1% per annum. There are no other charges.
The company is considering two alternative new contract designs.
Design A allocates all of the first year s premium into capital units which have an
annual management charge of 6% per annum. Subsequent premiums are invested into
the existing accumulation units. A surrender charge is applied and is equal to the
actuarial value of the future charges on capital units in excess of 1% per annum.
Design B invests a constant proportion of each premium into the existing
accumulation units. This proportion is higher than that currently invested in the first
year. A surrender charge is applied and is equal to the actuarial value of the
proportion of the future premiums that are not invested into units.
(i) Outline the advantages and disadvantages to the company of Designs A and B
relative to the current product. [5]
(ii) The Finance Director has asked whether it would be desirable to use actuarial
funding in Design B. Describe the points you would make in your reply. [8]
[Total 13]
ST2 A2006 3 PLEASE TURN OVER
4 (i) Describe how a company can use underwriting, when a policy is written, to
manage mortality risk on term assurance business. [4]
A life insurance company has written term assurance business for many years and
used to sell all its business through independent financial advisers. Five years ago,
the company started selling term assurance contracts on the internet, using simplified
underwriting to determine whether a proposal is accepted. Since then the company
has written a substantial amount of business, becoming the leading provider of
internet term assurance in the country in which it operates.
The actuarial department has just completed a detailed analysis of the mortality
experience since the internet contract was launched and has found that the mortality
experienced on the internet business is substantially lighter than allowed for in the
pricing basis. Their findings also show that the mortality experienced on the internet
business is substantially lighter than the mortality experienced on the business sold
through financial advisers.
(ii) Discuss the factors that may have contributed to the mortality experienced on
the internet business being lighter than allowed for in the pricing basis. [4]
(iii) Discuss the actions that the company may take as a result of this mortality
investigation. [6]
[Total 14]
ST2 A2006 4
5 (i) State the investment principles applicable to a life insurance company. [2]
A small mutual life insurance company currently sells without profits term
assurances, immediate annuities and unit-linked business. In addition, it has a small
mature existing portfolio of conventional with profits business, although it no longer
sells this.
The results of the most recent statutory valuation are summarised in the balance sheet
shown below. The liabilities have been calculated in accordance with the local
regulatory requirements which require supervisory reserves to be held only in respect
of guaranteed benefits, including declared reversionary bonuses.
Assets 000 Liabilities 000
Domestic equities 4,500 Conventional with profits business 3,000
Overseas equities 1,500 Term assurances 3,000
Direct property holdings 1,000 Immediate annuities in payment
- level annuities
- index-linked annuities
11,500
500
Fixed interest
- Government
- corporate
- index-linked
7,750
7,000
250
Unit-linked contracts
- internal linked funds
- non-unit reserves
14,000
1,000
Cash/Deposits 3,250 Regulatory solvency requirement 1,000
Assets held in internal linked funds 14,000 Surplus assets 5,250
TOTAL 39,250 TOTAL 39,250
(ii) Describe an appropriate asset mix for each of the items on the liability side of
the balance sheet (the current asset mix should be ignored). [10]
(iii) Discuss briefly the current asset mix of the company and suggest any changes
that may be appropriate. [6]
[Total 18]
ST2 A2006 5
6 (i) Describe the profit criteria a company could use to assess the profitability of
its products and when each of these criteria may or may not be appropriate. [7]
A life insurance company writes unit-linked savings products that invest in assets
managed by the company s in-house fund managers. The Marketing Director has
noticed the investment performance of the internally managed funds has recently been
poor. She has suggested that the company allows access through its products to a
range of funds that are managed by an external fund management specialist.
(ii) Discuss the main issues the company should take into account in considering
this suggestion. [11]
[Total 18]
7 A life insurance company has, for several years, been one of the leading providers in
its country of without profits immediate annuities. One of its actuaries has raised
concerns regarding the level of mortality risk arising from this business.
(i) Discuss briefly the different types of mortality risk that the company faces.
[3]
(ii) Describe how the company could mitigate these risks for new business. [6]
(iii) Describe briefly the other risks that the life insurance company might face as a
result of selling this business. [8]
It has been suggested that the company should not worry about the risk of lower than
expected future mortality, because the extra amount of annuity that would have to be
paid would have a relatively small impact on profitability since the payments happen
a long way into the future.
(iv) Discuss this suggestion. [5]
[Total 22]
END OF PAPER
Faculty of Actuaries Institute of Actuaries
EXAMINATION
April 2006
Subject ST2 Life Insurance
Specialist Technical
EXAMINERS REPORT
Introduction
The attached subject report has been written by the Principal Examiner with the aim of
helping candidates. The questions and comments are based around Core Reading as the
interpretation of the syllabus to which the examiners are working. They have however given
credit for any alternative approach or interpretation which they consider to be reasonable.
M Flaherty
Chairman of the Board of Examiners
June 2006
Comments
Individual comments are given after each question and within each part question where
relevant.
Faculty of Actuaries
Institute of Actuaries
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1 The cost of the guarantee is such that the insurer will have to meet the difference
between the guaranteed maturity value and the unit fund only if the unit fund is less
than the guaranteed maturity amount at maturity.
Hence the insurer is trying to measure the likely size of this gap between the
guaranteed maturity value and the unit fund and the probability of the unit fund being
less than the guaranteed maturity value.
The unit fund will need to be projected using best estimate assumptions (e.g. for
withdrawals, mortality). The modelling may use appropriate model points that
represent the existing business.
The insurer will need to use a stochastic model to simulate the likely behaviour of the
investments underlying the unit fund.
Care must be taken in setting up the model to ensure that it reflects the likely
behaviour of the investments underlying the unit fund and also that the assumptions
made in constructing the model also reflect the company s investment strategy.
A large number of simulations will be carried out so that a distribution of the likely
outcomes at the maturity date is created.
For each simulation the present value of the liability can be determined by taking the
difference between the guaranteed maturity amount and the expected fund size and, if
bigger than zero, discounting it back at a suitable rate to the start date of the policy.
The repeated simulations allow the company to create a probability distribution of the
cost of the option.
The company will then set the charge for this guarantee having a present value that
ensures that the expected present value of the average cost of the option is covered
with an appropriate probability level.
Comments on question 1: Candidates generally answered this question satisfactorily.
However many candidates failed to explain what the cost of the guarantee to the insurer
would be, and failed to demonstrate adequate knowledge of the process that would be used
to calculate the cost of the guarantee.
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2 (i) In general offering a surrender value may be seen to be in line with treating
customers fairly, and matching policyholders reasonable expectations.
In the early years premiums are higher than the cost of life cover. Part of the
excess is used to build up a reserve for the later years of the policy when the
cost of cover exceeds the level premium. At the limit of life, the reserve will
equal the sum assured.
On surrender there will therefore be a release of reserves.
Hence a surrender value can be paid without causing the company financial
strain.
Offering a surrender value could be viewed as fair treatment for those clients
who exit having paid more in premiums than the value of the benefit they
would otherwise receive.
There may be regulations that require a surrender value to be paid.
Competitors are likely to offer surrender values, hence a policy without a
surrender value will prove difficult to sell.
(ii) Pros
There may be a benefit from increasing the surrender values in terms of
reduced admin costs since less time will be spent dealing with complaints.
If mortality experience has improved since the policies were priced, then it
may be possible to increase surrender values whilst maintaining profits at the
originally targeted level.
New business levels may increase as a result of higher surrender values and as
a result of avoiding bad publicity
Cons
Increasing the surrender values will reduce the profit that the company makes
per policy.
It may also lead to an increase in surrender rates.
This is a particular risk if it leads to lapse and re-entry, or to selective
withdrawals. This will depend on the premium rates for new business.
This will also act to reduce the profit that the company makes on the business.
Since the death benefits are guaranteed, these cannot be reduced to
compensate for the higher amount paid on surrenders.
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Despite the survey, there may be little demand for higher surrender values
since this will have been sold as a protection rather than a savings product.
The pricing of the product may have balanced a lower surrender value with a
higher death benefit.
General comments
Considering the existing business in isolation, the suggestion is unlikely to
make sense.
Increasing surrender values may not, by itself, improve surrender rates.
Whilst the surrender values could be increased just for new business to gain
this benefit, this may introduce administrative complications and the company
may feel that it wants to treat its existing customers consistently with new
policyholders.
Given these policies are really sold for protection, the most efficient way to
attract new business is likely to be via improving death benefits per unit of
premium rather than by increasing surrender values.
It is possible that the beneficial impact on total profits from new business
would outweigh any negative impact on existing business profits.
The company will need to consider the reserving implications and whether it
can afford to actually increase surrender values without having a material
impact on solvency.
If premiums are increased to pay for the higher surrender values, the
company must consider the implications for the marketability of the product.
Comments on question 2: In part (i) many candidates failed to explain that significant
reserves would be built up under a whole of life contract. Part (ii) was poorly answered.
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3 (i) Design A
+ Can present a higher unit allocation in first year of policy.
+ Impact of charges not as apparent the capital unit charge emerges
through a lower unit fund price.
+ Can use actuarial funding to reduce new business strain (alternatively a
disadvantage is that the new business strain is higher unless actuarial
funding is used).

Need to calculate capital unit prices for all funds.

Client unit statements and systems will have two types of unit.

Surrender penalties will need to be calculated.

Design is complex and difficult to understand.

May not be in line with local regulations or industry standards
Design B
+ Allocation to units is higher in first year than the current product so more
marketable.
+ Less likely to require non-unit reserves as margins emerge over the life of
policy in line with maintenance costs.
Although this is only as a result of higher new business strain

Initial costs not recovered as quickly from policy. This will increase new
business strain.

If a policy stops paying premiums (becomes paid up ) prior to the full
recovery of initial expenses there will be limited future charges from
which to cover initial expenses
It may be possible to reduce non-unit supervisory reserves by holding negative
non-unit reserves (depending on regulatory regime).
For either design the surrender values will appear inconsistent with
policyholders perception of value of the policy.
For either design the balance between marketability and profitability needs to
be taken into account, as well as the impact of competitors.
(From the information given in the question it is not possible to make any
specific comments on profitability.)
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(ii) Actuarial funding can be used by the company to hold reduced unit reserves in
certain circumstances in order to reduce new business strain.
The usual requirements are that there is a unit related charge and a surrender
penalty expressed as a percentage of the allocated units.
The unit related charge is required so that, if fewer units are purchased in the
early years, then the charge will be exactly sufficient to purchase more units in
the later years. Both the price of the units and the amount of the charge will
move directly in line with the fund growth.
Design B has future charges that are mainly expressed as a percentage of the
premium, which is a monetary amount.
The annual management charge on the accumulation units is only 1% per
annum and so actuarial funding of this amount will not materially reduce new
business strain.
If fewer units are purchased in the early years and more purchased in later
years from the premium charge, then the insurance company will take on more
risk.
This is because the charge will not behave in the same way as the cost of unit
purchase the price of the units will rise or fall in line with the fund
performance.
The company may have to hold non-unit supervisory reserves to mitigate this
risk assuming a prudently high rate of future unit growth.
The surrender penalty is also expressed as a percentage of a monetary amount.
Therefore, there is an exposure on early surrenders or paid ups, as the units
actually held in the unit account may or may not be sufficient to pay the
defined encashment value.
Therefore, the company may have to hold additional non-unit supervisory
reserves to cover this risk.
Since the two contingencies are mutually exclusive, the additional reserves
would be the higher of the amounts obtained from the two calculations.
Holding additional non-unit supervisory reserves would reduce the benefit
obtained from actuarial funding (and holding lower unit reserves).
There is also the risk of a real loss arising from the market exposure.
Therefore, this is not a recommended course of action and is probably more
appropriate for Design A.
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Comments on question 3: This question was poorly answered. In part (i) many candidates
failed to understand that the low initial allocation rate in the original contract was designed
to meet initial expenses. In part (ii) candidates did not demonstrate an understanding of
actuarial funding.
4 (i) Underwriting at the new business stage can be used to help protect a company
from anti-selection by identifying those lives that are in such poor health that
they should be declined and by identifying substandard lives who should be
offered special terms, such as charging additional premiums or imposing
exclusions.
The underwriting process will help determine the most suitable special terms
to be offered to substandard lives and the level of the special terms to be
offered.
The underwriting process will therefore help to ensure that all lives are treated
fairly and charged for appropriately.
Underwriting will help to ensure that the actual mortality experienced by a
company s portfolio of business is not too different from that assumed in the
pricing basis.
Financial underwriting can be used to reduce the risk of policyholders over-
insuring themselves by ensuring that the cover requested is in line with the
policyholders financial situation/requirements.
(ii) The factors that may have contributed to the mortality experienced on the
internet business being lighter than anticipated in the pricing basis include:

The company may have been very conservative in setting its mortality
assumption for the business to be sold through the internet and hence used
a heavier mortality assumption than has been experienced in practice. It
may have done this due to its inexperience in using simplified
underwriting to accept business and hence wanted to build margins into its
mortality assumption.

The company may have wanted to control the amount of business it wrote
through the internet due to uncertainty regarding the experience of the
portfolio and hence it may have overpriced the contract initially by
assuming a heavier mortality assumption to ensure that it did not write
more business than it wanted to.

The actual mortality improvements experienced over the past five years
may have been greater than those assumed in pricing the internet product.

The simplified underwriting process may have been designed so that only
those applicants who answer a small number of strict questions on line
appropriately are accepted, with any other responses meaning that the
request for cover is rejected. Hence the most substandard lives, with health
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issues likely to lead to heavier mortality/additions to premiums (if the
cover had been taken out using full underwriting) may have simply been
excluded from taking out the internet cover. This would lead to lighter
mortality for this book of business overall since the worst risks are likely
to have been excluded from cover.

If the company had originally charged the same rates for both IFA and
internet business, it may not have appropriately allowed for the different
target markets for the internet business (e.g. different age/lifestyle
categories).

The company may have been more successful than anticipated at targeting
these groups, with take up from these groups being higher than expected
leading to overall lighter mortality amongst the internet policyholders than
expected in the pricing basis.
(iii) The company may choose to reduce the premium rates on its internet term
assurance business if it wishes to write more business through this channel and
offer even more competitive premium rates.
This would lead to the company making a lower unit profit on each term
assurance policy sold, but it may lead to higher overall profits if the volume of
business it sells through this channel increases significantly as a result of
reducing premium rates.
If volumes increase dramatically then the company would need to consider the
capital requirements as a result of any increased new business strain, and
would need to ensure that it was in a position to administer such an increase in
new policies.
However, we are told that the company is already the leading provider of
internet term assurance business, so it may be that volumes will not
significantly increase if it reduces premium rates across the board and so
profits may not increase if it cuts rates. Hence one option is to leave the
premium rates unchanged.
Another option is for the company to analyse the particular age
bands/genders/segments of the population where it currently doesn t write as
much business as it would like and make selective decreases in premium rates
to increase business volumes in those segments.
For example, it may be that one of the company s competitors particularly
targets women of certain age groups and the company could therefore look at
reducing its premium rates to women in the same age categories to win a
greater market share, whilst still remaining profitable.
The company may decide to relax its underwriting policy and accept more
substandard lives if it feels it can do this profitably. For example, rather than
rejecting those lives that answer any of the simplified underwriting questions
Subject ST2 (Life Insurance Specialist Technical) April 2006

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negatively, the company may request the proposer to fill in a more detailed
questionnaire on line and then accept the life at a higher premium.
If the internet term product overall is very profitable, due to low mortality and
low expenses (e.g. due to on-line applications/low admin costs and low
underwriting costs) and the mortality experienced on the adviser business is
heavy/unprofitable then the company may decide to withdraw from the adviser
market and choose to continue solely marketing its term product through the
internet.
However, this may be unlikely since companies may need to offer a term
assurance contract via IFAs (even one that is uncompetitively priced) to show
that they offer the full suite of insurance products in the adviser market. They
may also not want to alienate IFAs .
The company may, however, increase the rates on its adviser term business to
encourage more potential policyholders to apply on line rather than taking out
the cover through an adviser.
The company may remove some of the terms and conditions it imposed on the
internet contract, in order to make it more attractive (which may slightly
worsen profitability but should increase volumes) e.g. removing any waiting
period before cover is effective, removing some exclusion clauses and so on.
The company will need to ensure that whatever action it takes in this regard,
that it does not become vulnerable to anti-selection.
The company may decide that its mortality experience is not long enough/of
sufficient volume to be able to draw any firm conclusions and may decide to
keep monitoring its experience but make no changes to its rates.
The company s experience may encourage it to offer other on-line contracts.
The company would need to look at all other experience investigations (e.g.
withdrawals, expenses) before deciding to change any product pricing.
The company may wish to review its reinsurance policy in light of the
mortality experience of this line of business
The company may wish to review the mortality assumptions used within its
reserving basis for the internet business
Comments on question 4: Whilst part (i) was generally well answered, a number of
candidates did not apply their knowledge to the question and simply repeated the bookwork
on the process of underwriting. In part (ii) candidates did not appear to understand
simplified underwriting, and its subsequent impact on mortality experience. Part (iii)
required a breadth of points relating to actions the company might take many candidates
failed to recognise this, and consequently did not score well on this part of the question.
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5 (i) Standard bookwork, credit was given for either definition.
Key investment principle is to select investments that are appropriate to
nature, term and currency of liabilities.
Investments should be selected to maximise overall return.
The extent of any departure from above will depend on level of free assets.
[Or Company should invest so as to maximise the overall return on the
assets, subject to the risk being taken on being within financial resources
available to it.]
(ii) Appropriate Asset Mix
Conventional With Profits Business
Reserves only cover guaranteed benefits (basic sums assured and declared
reversionary bonuses).
Need to provide match for these most likely match being portfolio of fixed
interest of appropriate term
Split likely between government and corporate bonds.
If sufficient surplus assets then may be able to invest some in real assets , as
long as probability of insolvency kept at acceptable level.
Term Assurance
Term assurance benefits are guaranteed in money terms.
There is a need to match this liability profile with suitable fixed interest
stocks.
Annuities in payment
Conventional Annuities benefits fixed in money terms and very long term.
Best match is fixed interest stocks.
To obtain a higher yield, and hence better pricing terms within the market,
may want to invest significant proportion in corporate bonds.
Index Linked Annuities benefits guaranteed in terms of price index.
Likely to match with index linked govt stocks if available.
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Unit-Linked
Liabilities in respect of internal linked funds should be matched with assets in
same funds.
Non-unit Reserves likely to be in respect of mortality benefits and future
expenses.
Hence portfolio of conventional fixed interest and index linked appropriate.
Solvency Requirement
Solvency requirement could be calculated as a percentage of liabilities,
therefore investment would follow overall asset split for liabilities. In general
it is likely this would be matched by low risk investments.
Surplus Assets
Surplus Assets also to be used to support any future discretionary benefits (e.g.
future reversionary and terminal bonuses).
Need to consider policyholder expectations and literature at start of policy.
They may expect reversionary bonus to at least remain at current level, if not
increase.
This would suggest some holdings in fixed interest.
Depending on literature given at outset, policyholder will expect terminal
bonus.
The surplus assets will generally comprise a higher proportion of real assets ,
especially if the percentage of total payouts made up of terminal bonus is high.
The surplus assets may be needed to finance new business strain, and hence
assets would need to be readily available to cover initial expenses.
General Points
Future administration expenses will be matched with index linked/real assets.
Need to have regard for any regulatory requirements.
Need to consider tax position of company, and any tax implications of
investing in certain asset classes.
Need to consider liquidity/cashflow requirements, ensuring there are very
liquid assets available to pay day to day expenses.
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(iii) Candidates were given credit for sensible arguments and discussion relating
to the matching of assets and liabilities.
Linked assets matched by internal linked liabilities so OK.
Index Linked bonds needed to match index linked annuities and part of non-
unit reserve currently only 250k in index linked bonds compared to
around 1m required. (500k for annuities and part of non-unit reserves]
It therefore ought to increase the percentage of assets held in index linked
bonds.
Other Fixed Interest is 14.75m compared to requirement to hold 11.5m in
respect of immediate annuities, 3m in respect of Non Profit term, 3m for
with profits business, and part of non-unit reserve and solvency requirement
hence need around 18m.
Similarly, real assets of equities/property amount to 7m and these are
required to match majority of free assets (5.25m).
Hence company must be matching some other liabilities (probably a
significant proportion of with profits guaranteed liabilities) by equities.
So ought to consider selling some equities or property and investing the
proceeds in fixed interest.
Cash holdings could be included in fixed interest but overall seems 10% in
cash would appear to be too much.
So may want to invest some of cash in fixed interest stocks, without
compromising need for short-term liquidity.
Company has high level of investment in direct property for a relatively
small fund may want to consider investing indirectly in property (e.g.
investment trusts) to achieve exposure.
7m held in corporate bonds compared with 11.5m annuity liabilities.
Whether this is reasonable likely to depend on whether can offer marketable
product and whether credit risk felt to be acceptable.
25% of equities are overseas. Appropriate to hold some overseas for
diversification of risk but need to consider whether currency risk is reasonable
in context of level of free assets.
Comments on question 5: All parts of this question were generally well answered.
Candidates gave well structured answers, particularly for part (ii).
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6 (i) Internal rate of return. (IRR)
This is the rate of return earned on initial capital invested in writing the policy.
It is calculated as the rate of interest at which the value of discounted future
profits equals the value of any initial outlay.
IRR may not exist or may not have a unique value for certain policies, for
example single premium policies.
IRR shows the return earned on capital invested so it is a useful measure when
capital is scarce.
Discounted Payback period. (DPP)
This is the length of time it takes for any initial capital outlay to be repaid.
In the calculation future cashflows are discounted at a chosen risk discount
rate.
IRR and DPP do not show anything about monetary profit levels or about
future cashflow profiles.
DPP is useful as it will demonstrate when scarce capital is fully repaid.
Net present value of profit. (NPV)

This represents the monetary value of future profits from the contract
discounted back to the start date of the contract at a chosen risk discount rate.
The NPV is often expressed as a percentage of premium income or initial
commission
The NPV shows total profit levels achieved. Economic theory states that an
investor would choose the option which gives the highest NPV.
The NPV is subject to the law of diminishing returns. If it were not then a
company that could sell one policy with a positive NPV could sell an
unlimited number of policies and increase the company value without limit.
However, NPV does not indicate anything about how effectively any initial
capital required has been used.
In practice, a combination of targets and other criteria is often used.
(ii) Current funds
The company would need to consider the period of time over which
performance had been poor and whether this was likely to influence the future
Subject ST2 (Life Insurance Specialist Technical) April 2006

Examiners Report
Page 14
sales or retention of its current business. It may be this was a small blip or the
savings market is not that sensitive to past performance.
The most important aspect of the company s funds performance is
performance relative to its competitors.
It may be that the investment markets in general have fallen and the companies
fund performance is not poor relative to these. Alternatively it may be that the
investment managers were constrained by a benchmark they were given and
this impacted on their performance e.g. they may be marketed as low risk
funds investing in lower yielding assets

It would also need to think about the impact on the brand of the group if it
used an external company and whether it had any detrimental impact on group
profits if this led to reduced attractiveness of the groups investment capability
in the eyes of external investors
Profits could also be reduced if it led to reduced economies of scale in the
investment management company
New Funds

If launching new funds it would need to consider the profitability of new
funds.

The charges for fund management may be higher than the cost of the
company s internal fund managers. If so the company would need to
market these funds with higher annual management charges than its
existing funds or accept a lower level of profitability.
In making this decision it would need to consider the attractiveness of funds
with higher charges
Marketability
The company needs to consider the marketability issues, and consider whether
this move is in line with competitor actions.
It would need to consider whether the historic investment performance was
any better for these funds making them more attractive
Would the funds be suitable for its target market? It is likely that a similar
range of asset classes are available but the risk profile of the funds may be
quite different.
The company would also need to consider whether the sales channels it
distributes through were comfortable selling these funds and were suitably
trained to be able to explain their features.
Subject ST2 (Life Insurance Specialist Technical) April 2006

Examiners Report
Page 15
Marketing literature, sales aids etc would all need to be developed to explain
the new funds.
Using external fund managers provides access to expertise that the company
currently does not have in-house
Systems
The administration systems would need to be amended to enable choices of
other funds to be made.
The company would need to set up links to enable appropriate cash
movements to be made on a daily basis in line with movements in policyholder
monies.
In addition their administration systems would need to have links created with
the external fund prices.
Also, if the annual management charge is changed this will lead to further
changes being required e.g. to quotation systems.
This is likely to have significant cost attaching which would need to be
factored into any business case.
General
The company would also need to consider whether to offer the new funds to
both new and existing customers. This could create lapse and re-entry issues.
Doing so may generate further administrative costs through switching activity.
However this may help the persistency of the business by offering more
investment choice or better performance records.
The company would need to consider any regulatory issues and any
restrictions that may be applied to using external fund managers
The company should consider any additional operational risks that it will be
exposed to as a result of using third party fund managers, and the potential loss
of control that may arise.
Comments on question 6: Part (i) was standard bookwork, and was well answered. Part (ii)
required candidates to consider a wide variety of issues. Many candidates concentrated only
on cost related issues and therefore failed to score well.
Subject ST2 (Life Insurance Specialist Technical) April 2006

Examiners Report
Page 16
7 (i) The risks are:

The assumptions chosen do not reflect adequately the class of lives
insured.

The assumptions chosen do not reflect adequately the expected future
trend in mortality improvements.

Even if the assumptions chosen are appropriate, the company is still at risk
from random fluctuations.
For this specific product, the key risk is that actual mortality will be lighter
than expected.
However, if options are offered that accelerate benefits (e.g. through
guaranteed periods) then this introduces a different type of mortality risk,
which might to some extent offset the longevity risk.
The extent of the first risk depends on the reliability and applicability of any
existing data.
As the company has been selling large volumes for several years, it may have
credible internal data.
However, the first two risks cannot be eliminated, as the future can never be
predicted with certainty.
The third risk will also be reduced as a result of the large volumes of in-force
business, but cannot be removed entirely.
(ii) Mortality by class of life
The company should perform detailed experience analyses in order to set its
pricing assumptions appropriately.
It should include adequate margins for risk in the mortality rates it uses in its
pricing assumptions.
The company might decide to introduce differential annuity rates to allow for
the expected mortality of lives e.g. in different states of health, different
regions, different socio-economic group. They could then manage this
particular risk using underwriting.
Subject ST2 (Life Insurance Specialist Technical) April 2006

Examiners Report
Page 17
Future mortality improvements
The company should include appropriate allowance for future mortality
improvements in its assumptions.
It should keep up to date with industry analyses and research.
The company could consider using mortality derivatives to reduce the risk of
future mortality improvements
The company could sell lower volumes, thus reducing its exposure to future
mortality improvements.
It could do this by withdrawing from the market, or by reducing its rates to a
less competitive level.
Random fluctuations
It could try to sell even higher volumes in order to reduce its exposure to
random fluctuations.
General
The company could take out reinsurance or use co-insurance. For example, on
original terms, or the reinsurer could pay all annuity payments beyond a
certain age, or beyond the age at which the policyholder is expected to live on
a specified mortality basis.
If the risk is currently borne fully by the shareholders of the company, then
they could reduce this risk by writing the annuities into a with profits fund (if
there is one) in order to share the risk with the with profits policyholders. This
would depend on the relative appetites for risk of shareholders and
policyholders.
Alternatively, the company could change the product design to with profits
rather than without profits immediate annuities, and share the mortality risk
with the annuitants through the bonus declarations.
It could launch or sell more products that have synergy with immediate
annuities, i.e. they generate higher profits if mortality rates reduce. For
example, term assurance written at similar ages.
(iii) Other risks are:
Mismatching and reinvestment risk: investment risk arising from imprecise
matching of assets and liabilities.
Default risk on corporate bonds if these are used to back the liabilities. This is
likely given that the company is a leading provider and so must be pricing
competitively.
Subject ST2 (Life Insurance Specialist Technical) April 2006

Examiners Report
Page 18
Market risk for the period between the issuing of the guaranteed quotation of
the annuity rate and the investment of the premium
Renewal expenses being higher than expected.
Expense inflation being higher than expected.
Volumes sold being lower than expected, leading to a lower contribution to
overheads and other fixed expenses.
Volumes sold being higher than expected, potentially leading to new business
strains (e.g. reserving strains) that exceed available capital.
Volumes sold being higher than expected, leading to strain on administrative
processes.
Change in mix of new business by size, i.e. more small policies.
Change in mix of new business by source, if assumption differences (e.g.
commission, mortality) are not reflected in differential annuity rates.
Anti-selection risk, particularly if this company offers only one set of annuity
rates and other companies introduce annuities targeted towards lives in poorer
health.
Inaccurate or incomplete data.
Fraudulent claims, e.g. not notifying the company of the death of the
annuitant.
If reinsurance is used, failure of a reinsurer.
Changes to the legal, fiscal or regulatory environment.
Changes in volumes and mix of business can be influenced by competitor
actions (e.g. a new company entering the market, or targeting a different
market) and can be influenced by management actions (e.g. incorrect decisions
regarding annuity pricing).
(iv) For new business, there is some truth in this comment because the impact of
mortality improvements would be discounted for a reasonably long period.
However, the overall financial impact on the company could be significant
given that they sell a large volume of new business.
There is also likely to be a large in-force portfolio, and the impact on existing
business could also be considerable.
Subject ST2 (Life Insurance Specialist Technical) April 2006

Examiners Report
Page 19
In particular, reserves must reflect a prudent expectation of future mortality. If
the rate of future mortality improvements is reassessed as being higher than
previously expected, then reserves would have to be increased to reflect this.
This could cause solvency problems, depending on how well capitalised the
company is.
If the portfolio is cashflow matched, then unanticipated mortality
improvements could result in mismatching losses, or would require
rebalancing of the assets, which could be costly.
The problems are exacerbated if further expected mortality improvements are
identified on a regular basis.
If the company writes escalating annuities, then the potential cost is greater
than if level annuities.
If the company writes impaired life annuities, then the impact of mortality
improvements within this class of life is proportionately of greater
significance.
Overall, the company therefore should manage this risk carefully.
Comments on question 7: Surprisingly parts (i) and (ii) were not well answered, with many
candidates identifying longevity as the only mortality risk the company faced. However parts
(iii) and (iv) were relatively well answered.
END OF EXAMINERS REPORT
Faculty of Actuaries Institute of Actuaries
EXAMINATION
13 September 2006 (pm)
Subject ST2 Life Insurance
Specialist Technical
Time allowed: Three hours
INSTRUCTIONS TO THE CANDIDATE
1. Enter all the candidate and examination details as requested on the front of your answer
booklet.
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 the
supervisor.
4. Mark allocations are shown in brackets.
5. Attempt all 7 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 this
question paper.
In addition to this paper you should have available the 2002 edition of the
Formulae and Tables and your own electronic calculator.

Faculty of Actuaries
ST2 S2006 Institute of Actuaries
ST2 S2006 2
1 A life insurance company sells regular premium unit-linked endowment assurance
policies. The insurance company is considering whether to increase the surrender
values it pays on these policies.
Discuss the factors it should consider. [7]
2 A proprietary life insurance company has been selling term assurance business for
many years. Recently, the company has been losing market share and has decided to
re-price the term assurance product.
Describe how the revised premium rates would be determined. [10]
3 (i) Describe the principles appropriate for setting the supervisory reserves for a
life insurance policy. [7]
A life insurance company writes regular premium unit-linked endowment assurance
policies. Premiums invested in these policies are allocated to Capital Units for the
first three years and to Accumulation Units after that. 100% of premiums are
allocated to units.
The benefits from this policy are:

On death the higher of the combined value of Accumulation and Capital Units
(no penalty is incurred on the Capital Units on death) or a specified amount set at
outset.

On surrender the combined value of Accumulation and Capital Units after any
penalty on the Capital Units (see below).

On maturity the combined value of Accumulation and Capital Units.
The only charges to the policyholder for this policy are:

Accumulation Units are charged an annual management charge.

Capital Units are the same as Accumulation Units except they have a higher
annual management charge.

For the death benefit

unit deductions are made each month based on the age of
the policyholder and the excess of the specified death benefit over the unit value.

On surrender a surrender penalty is charged as a percentage of the value of the
Capital Units. The percentage used decreases the longer the policy has remained
in force.
(ii) Describe how the supervisory reserves may be calculated for these policies in
a way that is consistent with the supervisory reserving principles. [8]
[Total 15]
ST2 S2006 3 PLEASE TURN OVER
4 A life insurance company sells immediate annuity, deferred annuity, endowment
assurance, whole life and term assurance policies. The company currently only
underwrites its term assurance policies.
(i) Discuss the forms of underwriting that could be used throughout the duration
of a term assurance contract and explain why they may be used. [8]
A member of the Board of Directors has heard that underwriting has helped improve
the profitability of the term assurance business and has suggested that the company
should extend underwriting to its other products.
(ii) Discuss this suggestion. [7]
[Total 15]
5 Describe briefly, suitable life insurance products that might be purchased by the
following customers, explaining how they meet the needs of the customer, and
whether they would normally be conventional without profits, with profits or unit-
linked.
(i) A recently married young couple, who plan to start a large family. [8]
(ii) A financial services company that employs 2,000 people. [7]
[Total 15]
6 A life insurance company writes conventional with profits endowment assurances.
(i) List the components that may be used to determine the asset share of a policy.
[4]
(ii) Discuss the issues the company would need to consider when determining the
investment return to credit to these asset shares, including any associated tax
issues. [9]
(iii) Outline how the asset share could be used to set an appropriate amount for:

the surrender value

the maturity value

the value payable upon death before maturity. [5]
[Total 18]
ST2 S2006 4
7 A new life insurance company entered the insurance market three years ago and offers
a wide range of conventional without profits and unit-linked contracts. Since launch
the company has suffered from very high lapse and surrender rates across the whole
range of its contracts. These rates are higher than those anticipated in its pricing bases
and higher than those experienced by the rest of the market.
(i) Describe why the company may be experiencing these high rates of lapse and
surrender. [8]
(ii) Discuss why the company is likely to be concerned about this. [7]
(iii) Discuss the actions that the company can take to improve its lapse and
surrender experience.
[5]
[Total 20]
END OF PAPER
Faculty of Actuaries Institute of Actuaries








EXAMINATION


September 2006


Subject ST2 Life Insurance
Specialist Technical


EXAMINERS REPORT


Introduction

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

M A Stocker
Chairman of the Board of Examiners

November 2006


Comments

Individual comments are shown after each question.















Faculty of Actuaries
Institute of Actuaries
Subject ST2 (Life Insurance Specialist Technical) September 2006 Examiners Report

Page 2
1 For unit-linked business, the amount payable on surrender is likely to be defined in
policy terms. Therefore, it is unlikely that the amount will be changed for existing
policies.

The company can amend the terms for new policies only, for marketing purposes

The surrender value scale will have formed part of the profit test originally carried out
when the product was priced. Therefore, if the company wishes to alter this amount,
it will need to re-run its profit tests assuming the new proposed surrender payment
definition.

The company would need to consider whether to amend its profit testing basis in light
of its proposed action. For example, if it is increasing surrender values, then it may
increase the lapse rate it assumes in the profit test. Alternatively it may use its
existing lapse experience, but reflect increased risk by increasing the risk discount
rate used to discount the cash flows.

The company would consider whether increasing the cost of surrenders still gave rise
to an acceptable level of profit.

The company would also consider whether there would be any impact on supervisory
reserves. The reserve cannot be less than the surrender values payable so these
reserves may increase. The capital strain from writing new business would therefore
also increase which, all other things being equal, would lead to a reduction in free
assets. If the capital available is limited, it may not be able to increase surrender
values.

If the company reduced the initial commission it paid, and increased the renewal
commission, then it may be able to offer higher surrender values with little financial
impact.

The company should consider whether competitors offer higher surrender values and
therefore whether higher volumes of new business may be obtained.

There may be regulatory restrictions on the surrender values that it offers.

The company should consider the possible impact on surrender rates resulting from
this move.

Comments on question 1: Question 1 was not well answered. Most candidates were able to
comment on the likely impact on profits and sales and the desire to maximise total
profitability. However, few considered fully the impact changes in surrender values may
have on reserves and the knock on impact on the capital position of the company. In addition
only the strongest candidates showed an understanding of practical issues such as the impact
on administration systems and restrictions from regulators.


Subject ST2 (Life Insurance Specialist Technical) September 2006 Examiners Report
Page 3
2 The company is likely to use cashflow model, based on existing model.

It needs to select a set of model points representing the expected new business under
the product. It could use profile of historic new business to set model points, but
allowing for any expected changes in the future. It needs to amend the model to allow
for any new features model points for any new features could be derived using
profile of similar product or by taking advice from the marketing department.

For each model point cashflows will be projected, allowing for reserving and
solvency margin requirements using a set of assumptions.

Assumptions for mortality, lapses and expenses will be based on the most recent
investigations allowing for any known distortions in the investigations and any
likely future changes. The assumptions for lapses and mortality may need adjusting if
the reprice is likely to change the customer profile from that in the past.

Economic, and valuation bases will be required. A risk discount rate will be set based
on the return required by the shareholders and allowing for a level of risk attached to
the cashflows.

The premium will be set so as to produce the required level of profit.

The premiums would then be considered for marketability.

This may lead to a reconsideration of:

the design of the product e.g. may add or remove features
the distribution channel to be used
the companys profit requirement
whether to continue with the product

The net cashflows for each of the model points will be scaled up for the expected new
business under the product and incorporate into a model of the business of the whole
company.

An analysis of the sensitivity of profit to changes in assumptions would need to be
conducted to assess any risks inherent in the premium rates.

The desired level of profitability may not always be reached for all individual model
points, but the overall level of profitability may be reached. In this case cross-
subsidies need to be considered particularly as there is a risk that the assumed
business mix will not be borne out in practice.

The capital requirements of the new contract can be considered by examining the
modelled cashflows in terms of timing and amounts. This may lead to further
redesigning of the product, or re-assessing the financing requirements (e.g. use of
reinsurance).

The company will also need to consider whether reinsurance terms need to be
renegotiated and allow for any revised terms in the profit test.
Subject ST2 (Life Insurance Specialist Technical) September 2006 Examiners Report

Page 4
It needs to allow appropriately for tax and to consider the possibility of lapse and re-
entry.

Comments on question 2:

Question 2 was well answered by many. A number of candidates described a cashflow
projection giving a good overview of the process and inputs required. Stronger candidates
also covered in their answers the iterations the company may go through to reach the final
premium rates, e.g. changing premium rates or redesigning product features and the benefits
of sensitivity analysis.

Some candidates lost marks by focussing too much on the detailed investigations behind
certain basis assumptions and failing to adequately describe the overall profit test process.


3 (i) The amount of the reserves should be such as to ensure that all liabilities
arising out of the contract can be met by the life insurance company.

The amount of these reserves should be calculated by a suitably prudent
actuarial valuation of all future liabilities for all existing policies including:

guaranteed benefits, including guaranteed surrender values (the amount of
the reserves for each policy should be at least as great as any surrender
value guaranteed and therefore should not be negative)

options available to the policyholder

expenses, including commission

taking credit for the premiums which are due to be paid under the terms of
each policy

A prudent valuation is not a best estimate valuation, but should include an
appropriate margin for adverse deviation of the relevant factors.

The valuation should take account of the nature, term and method of valuation
of the corresponding assets.

The use of appropriate approximations or generalisations should be allowed.

The rate of interest used in the calculation of the non-unit reserves should be
chosen prudently, taking into account the currency in which the policy is
denominated, and having regard to the yields on the corresponding existing
assets and to the yield which it is expected will be obtained on sums to be
invested in the future.

The elements of the statistical basis, that is the demographic and withdrawal
assumptions, and the allowance used for expense in the calculation of
reserves, should be chosen prudently, having regard to the type of insurance,
Subject ST2 (Life Insurance Specialist Technical) September 2006 Examiners Report
Page 5
the country where the insured people live, and the administrative costs and
commission expected to be incurred.

If the method of valuation defines in advance the amount of expenses to be
used in the valuation, the amount so defined should not be less than a prudent
estimate of the relevant future expenses.

The method of calculation of the reserves from year to year should be such as
to recognise profit in an appropriate way over the duration of each policy and
should not be subject to discontinuities arising from arbitrary changes in the
valuation basis.

Each life insurance company should disclose the methods and bases used in
the valuation.

(ii) The reserve will need to ensure that the policyholder liabilities are met on
death surrender and maturity. In addition, the reserve will need to ensure that
the expenses of the company are met.

The reserve cannot be less than the guaranteed surrender value. It is unlikely
that the company will pay out a surrender value higher than that guaranteed in
the policy conditions.

The reserve will consist of two parts: a unit reserve and a non-unit reserve.

The unit reserve will be the face value of the units. As there is a penalty on
the Capital Units the company may choose to use Actuarial Funding as a
method to reduce the reserve.

Non-unit reserve

By allowing for future premiums and the allocation of those premiums to units
in accordance with the policy conditions, it is possible to project the unit fund
in the future.

Again, with reference to the policy conditions, it will be possible to project the
charges that the company might receive from the policy.

It will also be necessary to project the expected outgo:

Cost of death benefit
Renewal expenses
Termination expenses
Investment expenses
Renewal commission

The expenses may be increased above a current prudent estimate to allow for
their possible level if the company were to close to new business. It will also
be necessary to allow for future surrenders if this increases the reserve, but this
is not usually the case.
Subject ST2 (Life Insurance Specialist Technical) September 2006 Examiners Report

Page 6
It is important to ensure that if the Capital Units have been Actuarially
Funded, then the annual management charge associated with those units
cannot be used in the above projections of income and outgo.

The assumptions should all be prudent and the assumption regarding the
growth rate of units should have regard to the assets into which the units are
invested.

The outgo less income is discounted at a prudent rate of interest that reflects
the currency of the policy and the assets in which the resulting reserve will be
invested. It is prudent to discount those future net cashflows only up to the last
point where there is a net cash outflow. This is because any subsequent
positive cashflow to the company may not be received if the policyholder were
to surrender at this point.

Whilst it is allowable to group policies together and value the group, it is
much more likely that policies will be valued individually so that the
comparison with guaranteed surrender value can easily be made.

Where the individual policy reserve calculation does not allow for a specific
risk a prudent global reserve for that risk may be set up

Comments on question 3:

Part (i) of question 3 was well answered with a number of candidates scoring full marks

Many candidates struggled on part (ii), however. Most identified the need for a unit reserve
and a non unit reserve but were unable to describe the calculation of non-unit reserves in any
detail, failing to utilise the contract details given in the question. Few demonstrated the
understanding of how these two types of reserve met the principles from part (i).


4 (i) The company could use underwriting at the policy application stage.

It could use medical underwriting to identify policyholders who were a higher
than normal risk, to assess what special terms or conditions should apply in
such cases, to make sure a fair premium is charged for each risk, or to
determine whether the life should be declined.

It is used to ensure that the company is not selected against.

It may also be required to comply with conditions of reinsurance
arrangements.

In addition the company may use financial underwriting to ensure the benefits
sought are reasonable given the applicants current earnings.

The underwriting may use questions on the proposal form to identify high risk
individuals for example through questions on health, occupation, hobbies,
Subject ST2 (Life Insurance Specialist Technical) September 2006 Examiners Report
Page 7
place of residence, and to identify applicants with current symptoms or
conditions which may influence the insurance risk.

These may be supplemented by further questions or medical reports or tests.in
order to clarify the extent on any conditions and how they should be reflected
in terms given.

In addition the company may use underwriting at the claim stage to ensure
claims are valid. In practice this is likely to be straightforward involving
receipt of a death certificate but may be enhanced if the product offers any
rider benefits relating to ill health. In addition, at the claim stage it may
investigate non disclosure of pre-existing conditions or whether an exclusion
clause has been triggered.

(ii) General

Underwriting should pay for itself and only be used if the cost is outweighed
by the benefit through the increase in premium rates for loaded cases and/or
lower claims costs.

The main outgo in Term Assurance is the cost of claims. As such underwriting
can significantly alter the overall costs incurred. Underwriting is therefore
appropriate for this type of business.

Whole of Life Assurance

The cost of death claims is again significant for this type of policy but less so
than for Term Assurance as the only risk is the timing of the death not whether
it occurs in the policy lifetime.

Initial underwriting may therefore be used but is likely to be less cost effective
than for term assurance.

Endowment Assurance / Deferred Annuity

For these products the main payout is in the form of a cash sum available to
spend, reinvest or purchase an annuity at the end of the policy term.

For endowments, early in a policys life the death benefit may be high in
relation to premium paid and so underwriting will be required, but perhaps not
to the same extent as for whole of life

It is also possible that it may be suitable for term assurance rider benefits
which may attach to the Deferred Annuity product or for Endowment
Assurance products written under trust to older lives.

Immediate Annuities

For annuity contracts the key cost element relates to the annuity payments
made. This is driven by the life expectancy of the policyholder.
Subject ST2 (Life Insurance Specialist Technical) September 2006 Examiners Report

Page 8
Underwriting could therefore be used in defining appropriate terms, but, with
the exception of impaired lives annuities, it is not standard practice to
underwrite annuities.

Conversely to Term Assurance a higher death risk from impaired lives would improve
terms available to an annuitant. Using underwriting would therefore identify lives to which
the company can give better terms.

To make the process economic the company would need to cover the costs of
underwriting and enhanced terms through reductions in benefits to standard
lives.

The company would need to consider the marketability of such consequences
and whether other companies used this approach. If the company is out of line
with the market by not underwriting, then a higher proportion of its business
may be normal lives, which would impact on its profitability.

Comments on question 4:

Part (i) of question 4 was bookwork and was well answered by most candidates but many
found part (ii) more challenging. Most candidates covered marketability and cost benefit
considerations in deciding whether to underwrite. Weaker candidates failed to consider the
principle features of the different contracts in the question, limiting themselves to a more
general discussion thus missing a number of marks.

Stronger candidates who showed understanding of the possible merits of and issues with
underwriting the different product types scored much better.


5 (i) Term assurance

Pays a lump sum on death within a specified period. For example, might set
the period as being until any children are no longer expected to be dependants.

This is needed in order to protect the spouse and any children against financial
loss due to loss of the main household income. It could also be needed to
repay the balance outstanding under a mortgage (if on a repayment basis) or
other loan.

It may not be needed if either are employed and the employer provides
adequate death in service benefits.

It is normally conventional without profits.

Endowment assurance

Pays a lump sum on the earlier of death or survival to a stated date. It may be
needed to repay an interest only mortgage.

Normally with profits or unit-linked.
Subject ST2 (Life Insurance Specialist Technical) September 2006 Examiners Report
Page 9
Pension contract, in either deferred annuity or endowment assurance form.

The key benefit is payment of a regular income (or a cash lump sum, which
can be used to buy an immediate annuity) provided the customer survives to a
specified date. It enables the customer to save part of their income now whilst
economically active in order to provide income in retirement.

It would not be needed if either are employed and the employer provides an
adequate corporate pension scheme.

Normally with profits or unit-linked.

School/University fees plan

This could be in the form of a savings contract, the proceeds of which can be
used to purchase a temporary immediate annuity when the children are of
school age or when they go to university.

It enables the customer to save in advance for payment of school fees, to
provide private education to the children when they are of an appropriate age.

The savings component would normally be with profits or unit-linked; the
annuity would normally be conventional without profits.

(ii) Individual (keyman) term assurance

Would be written on the lives of key personnel, providing payment of a lump
sum on their death. It gives the company protection against financial loss
from the death of key members of staff.

Normally conventional without profits.

Group term assurance

Provides benefits on the death of a member of staff, normally to their
dependants. Offering such benefits as part of the employment contract meets
the customers need of retaining and attracting good staff.

Normally conventional without profits.

Group pension scheme, in either deferred annuity or endowment assurance
form.

Provides retirement benefits for the staff. The cost could be shared with the
employees by making the scheme contributory.

As above, this meets the customers need of retaining and attracting good
staff.

Normally with profits or unit-linked.
Subject ST2 (Life Insurance Specialist Technical) September 2006 Examiners Report

Page 10
Immediate annuities

The company might purchase immediate annuities in order to provide
retirement benefits emerging from the pension scheme. This removes
longevity risk from the company.

Normally conventional without profits.

Comments on question 5:

Answers to question 5 were mixed. Most candidates were able to identify the basic needs in
both situations and identify suitable contracts. Some candidates thinking was however fairly
narrow, being limited to death benefits and savings in part (i) and death benefits and
pensions in part (ii). Candidates who thought more widely generated more marks. In
particular only the strongest candidates considered keyman assurance in part (ii).

A number of candidates lost marks as they failed to explain their choice of whether a contract
would be likely to be conventional or unit-linked etc. Marks were given for valid reasons as
to why a contract was likely to be conventional, unit-linked etc.


6 (i) Premium
Investment income
Realised capital gains/losses
Unrealised capital gains/losses
A share in the profits from without profits business sold by the with profit
fund
Initial commission
Renewal commission
Expenses associated with acquiring and setting up new policies
Ongoing administration expenses
Investment expenses
Cost of any death benefits
Cost of any further benefits under the policy (e.g. waiver of premium)
Surrender profits or losses
Charges of any options or guarantees
Tax
Contribution to the transfer of profits to the shareholders
Cost of capital to the contract whilst asset share is negative
Contribution to free assets to support a smoothing policy

(ii) It is unlikely that different returns will be allocated to each individual policy.
In fact this would go against the pooled nature of with profits business.

Key will be to decide the asset mix appropriate for the class of business.

Subject ST2 (Life Insurance Specialist Technical) September 2006 Examiners Report
Page 11
First, consider whether the overall asset mix of the fund is appropriate for the
endowments. If not, actual assets held will be hypothecated to the separate
classes of business written by the company. This will give the actual assets for
the endowment policies we are considering.

Next it will be necessary to decide how these assets are hypothecated between
different subsets of the endowments. The same asset mix could be assumed for
all of the endowments. Or a more sophisticated hypothecation could be used
within the endowments.

For example, it may be reasonable to allow for some matching of assets and
liabilities. So more of the fixed interest assets may be allocated to the policies
very close to the maturity date. Similarly, shorter dated fixed interest assets
would be allocated to these policies. Alternatively, there may be a large
element of terminal bonus so that policies close to maturity have a high
proportion of real assets.

This will lead to the grouping of the policies into reasonably homogeneous
groups, but practical considerations will dictate the number of these groups.

Again, for practical reasons, this is likely to be simplified to an asset mix that
varies as the policy ages.

The asset mix may be influenced by the information provided to the
policyholder.

The historic year on year returns for each asset class would then be applied to
these asset shares in each year of the policy. As investment expenses are
usually expressed as a percentage of funds under management, it is common
for this to be netted off against the yield.

The tax impact could be based on the actual tax paid. Or it could be based on
notional tax rates applying each year. The latter approach would require an
assumption about the turnover rate of assets so that an estimate of the tax on
unrealised gains is made.

Further practical issues would be:

One-off jumps in asset values (for example, the sale of a large property)?

Uneven flows of premium over the year when returns are not even over the
year?

Data quality issues and timeliness of receiving data.

Deciding how frequently to carry out the calculations.

Subject ST2 (Life Insurance Specialist Technical) September 2006 Examiners Report

Page 12
(iii) Surrender value

The asset share is likely to be the long term average payout for surrender
values.

Unless the company has a policy of trying to build up free assets and this
policy has been communicated to the policyholders.

The surrender value will depend upon other factors, other than asset share,
such as ease of calculation, consistency with other values (e.g. blending into
maturity value), competition, past practice (and hence policyholders
expectations) and smoothing.

Maturity value

May be subject to a guaranteed minimum so asset share has no impact of the
guaranteed minimum bites.

Again, the maturity value will be based on average asset share over time.

It will depend heavily on the smoothing policy and so a particular maturity
value may be above or below its asset share.

The bonus rates are likely to be based on the asset share for an average policy,
rather than each individual policy

Death benefit

It is likely that the death benefit will be guaranteed in some way.

As such the asset share is unlikely to play a part in the calculation of the death
benefit.

However, close to maturity it is possible that the asset share is greater than the
guaranteed minimum and so this is likely to be paid in this case.

Comments on question 6:

Answers to question 6 were in general disappointing. Part (i) was reasonably well answered
but many candidates lost marks by not giving as much detail as was possible. For example
many mentioned expenses but did not split this into initial and renewal expenses,
administration and investment expenses etc.

Very few candidates scored well on part (ii). The question required consideration of how the
overall investment returns would be allocated to different tranches of policyholders through
the hypothecation of assets. This was only covered by a few candidates.

In part (iii), many candidates were able to set out basic considerations but failed to enrich
their answers with examples of situations where there may be deviations from normal policy.
Subject ST2 (Life Insurance Specialist Technical) September 2006 Examiners Report
Page 13
For example few set out how guaranteed death benefits may exceed asset share in the early
years of a contract.


7 Throughout this solution, the terms lapse and surrender have been used
interchangeably.

(i) High lapse rates are often an indication that products are not meeting
customers needs and that there might be a mis-selling issue.

It may be that one sales channel is worse than the others.

If the company sells some business through a sales force and this is the
channel where the lapse rates are highest, then it is likely that the following
problems exist:

The sales force may be incentivised to write as much new business as
possible without any incentives to ensure that policies do not lapse at
renewal. The sales forces remuneration/bonuses may all be geared to
writing new business rather than rewarding renewing business in any way.

The sales force may be suffering from a lack of training and product
knowledge and hence selling products to customers that do not meet
customers needs, resulting in customers lapsing their policies in the first
few months/years after inception.

The company may offer uncompetitive premium rates. The sales agent
may be able to make a sale but shortly after the policy may be lapsed by
the policyholder when they find out that a similar product is available
elsewhere for a lower premium. This is likely to be a significant risk for
term assurance business.

If the company sells business through independent advisers and/or third party
distributors such as banks and it is these channels that have the highest lapse
rates then it may be that the company is remunerating the independent
advisers/3
rd
parties more than other life insurance companies in the market,
which is encouraging the mis-selling of policies in order to get the high
commissions on offer.

The company may have charging structures that are out of line with the rest of
the market and in particular it may not have imposed surrender penalties (or
sufficiently high surrender penalties) to disincentivise policyholders from
surrendering their policy.

For example, if the company offers a single premium unit linked savings
contract with little or no penalty on withdrawal, then policyholders may lapse
their policies when they require the funds for an alternative purpose there is
no disincentive for them to invest in the product for only a short period of time
unless some kind of surrender penalty is applied.

Subject ST2 (Life Insurance Specialist Technical) September 2006 Examiners Report

Page 14
Alternatively, on unitised business, rather than applying a surrender penalty on
early withdrawal, the company may incentivise policyholders by awarding
bonus units if their contract remains in force. However, the level of bonus
units that this company awards may be too low and may not provide sufficient
incentive for policyholders to keep their policies in-force.

The company may be experiencing high surrenders if the fund performance is
poor when compared to the rest of the market/other investments.

The policyholder may have too many opportunities to lapse their policy.

For example, for regular premium business, if the company does not offer an
electronic form of premium collection and the premium has to be paid by
cheque or cash then the insurer is relying on the policyholder taking an action
at each premium anniversary to keep the policy live.

If, on the other hand, all of the insurers competitors are offering electronic
premium collection for regular premium business, their policies are much less
likely to lapse since the policyholder has to take some positive action (such as
cancelling an electronic payment order) to lapse the policy.

It may be that competitors have introduced new products that are more
attractive resulting in policy lapses. Since the company is young, its
policyholders are unlikely to have built up any strong loyalty to the company
and hence policyholders may be more likely to lapse their policies than if they
had been investing with the company for many years.

There may have been adverse press reports about the company resulting in
policy lapses e.g. if there is uncertainty about the ownership of the company/it
is the subject of merger/takeover rumours, policyholders may lapse their
policies and invest in a company with a better reputation. In addition,
policyholders will be more likely to lapse their policies if there are concerns
regarding the solvency position/financial strength of the company especially if
this has been reported on in the press.

The company is relatively new so it may have had teething problems with its
administration systems and customer service especially as business volumes
started to grow. Hence policyholders may be lapsing their policies due to the
poor level of customer service they are receiving.

It is possible it is due to increases in the companies own reviewablw premiums
or charges

(ii) Losses on individual policies

Whether high lapse rates lead to losses for the company will depend on
whether the initial losses have been recouped and the relationship between the
surrender value paid and the value of the future profits lost.

Subject ST2 (Life Insurance Specialist Technical) September 2006 Examiners Report
Page 15
If the initial loss has been recouped, then the company has not made a loss on
that policy, but it will have lost out on any future profits. The financial impact
of those lost future profits will depend on the level of any surrender penalty
charged.

In some markets, the level of commission that can be paid to an agent may be
controlled by regulations and may be relatively low and hence the risk of loss
on early lapses may not be as great as in markets where commission levels are
high (a multiple of the annual premium for example).

Clearly where the asset share is negative at the time of lapse, then the
company is making a loss, with initial expenses and commissions paid being
higher than the premium income received and the company will want to
concentrate its efforts on ensuring that in such classes of business (e.g. term
assurance where initial underwriting costs are likely to be relatively high
compared to the premium) lapses are minimised.

For unit linked business it is likely that the company will have incurred high
up front costs and these are unlikely to have been matched well by the up front
charges on the contract. Hence if a unit linked contract is lapsed early in the
policy term, the insurer is likely to make a loss and the insurer will no longer
have a chance to recoup its expenses from the annual management charges it
would have taken had the contract remained in force.

However even if the company is not financially worse off due to a policy
surrendering, the fact that the company is experiencing high lapse rates will
still be an area of concern:

Indicative of underlying problems

The life insurer is likely to be concerned about the high lapse rates it is
experiencing because the high lapse rates are likely to be indicative of
underlying problems/risks that the company is facing.

For example, the high lapses may be indicative of problems regarding the
competitiveness of its premium rates or contract design, which will not only
affect the companys lapse rates but also its ability to write new business as
well.

The high lapse rates may be indicative of mis-selling practices, which may
lead to the company being forced to pay compensation at a later date. If the
distribution channels are owned/controlled by the company, for example, a
tied agency force, then the company will want to ensure that business is not
mis-sold by them, since not only will this affect the reputation of the company
in the market but it may also mean that the company is exposed to the risk of
litigation in the future due to the mis-selling.

The high lapse rates may also be indicative of problems such as a lack of
training/product knowledge.

Subject ST2 (Life Insurance Specialist Technical) September 2006 Examiners Report

Page 16
It is possible that poor customer service is a cause. This could lead to the
brand name suffering and volumes of new business falling.

For savings contracts, the fund performance may have been worse than that of
competitors.

Lower level of in force business/expense overruns

One of the main causes for concern for a relatively new insurance company
suffering from high lapse rates will be the impact that the high lapse rates have
on the level of in-force premium.

The high lapse rates will erode the in-force premium, so that even if the
company is writing relatively high levels of new business premium income,
the in-force book will not be growing in the way that was anticipated in
business plans.

In the early years of operation a new insurer will have expense overruns,
meaning that the expenses it suffers are higher than the expense loadings
incorporated into its products when pricing the business. This is because the
company suffers from relatively high set-up costs (e.g. establishing a head
office, building distribution channels such as branch networks and so on) in
the initial years when business volumes are low. Only once the in-force
volumes of business are sufficiently large will the expense loadings built into
the premiums charged be sufficient to meet the actual expenses being incurred
by the company.

If the in-force premium is eroded by high lapse rates then the company is
likely to be in a position of having an expense overrun for more years than
anticipated, resulting in the insurer requiring capital support for more years
than expected from shareholders.

In addition, the higher expenses are likely to mean that higher reserves will be
required.

Also, the high level of lapses will lead to higher than budgeted levels of
administration costs due to the processing of the claims and handling any
complaints.

The surrenders may also be selective and so may lead to worsening mortality
experience for the company.

(iii) The actions the company can take to improve its lapse experience include:

Carrying out a detailed study of the lapse experience to identify the contracts
where the lapse rates are out of line with the market and the distribution
channels where the lapse rates are out of line with the market.

For the policies that have lapsed, carry out a survey of customers to find out
why the policy lapsed to identify the root causes of the lapses occurring.
Subject ST2 (Life Insurance Specialist Technical) September 2006 Examiners Report
Page 17
Use the survey to assess whether poor customer service is contributing to the
high lapse rates and take actions to improve service if this is the cause of the
problem.

Ensure the sales process leads to best advice to reduce the risk of mis-selling.

Establish a customer service unit/sales force unit to target policies that lapse
and try to reinstate them.

Provide the sales team with information regarding policies coming up for
renewal to ensure that the policies are actually renewed and that they dont
lapse on the renewal date.

Identify if there are deficiencies in the sales remuneration structures offered by
the insurer. If deficiencies are found (for example, there are no incentives to
renew business only to write new business), make amendments to the schemes
to achieve a better balance between incentivising the writing of new business
and the rewarding of business that renews and remains in force.

Identify if there are technical deficiencies in the service offered to customers
that is likely to increase lapse rates e.g. for regular premium paying
policyholders, ensure that premiums are collected efficiently by introducing
automated payment methods.

Compare the companys products to those available in the market and assess
their competitiveness, in terms of premium rates and the attractiveness of the
features offered.

If the companys products are not as attractive as others available, consider
repricing some or redesigning them to make them more attractive.

Equally ensure that policyholders have a disincentive to lapse their policies by
applying adequate surrender penalties when a policy lapses.

Alternatively, introduce loyalty bonuses to encourage them to keep the policy.

If the company has a poor solvency position then the shareholders could inject
more capital to increase confidence in the company.

If one of the reasons for policyholders lapsing their policies appears to be
concerns regarding the companys brand image/reputation, then the company
will need to invest by spending on advertising and promotion to improve its
brand image in the market place.

If the company has poor investment performance, it could change its
investment management team to improve performance.

The company could also look to change its target market or distribution
channels

Subject ST2 (Life Insurance Specialist Technical) September 2006 Examiners Report

Page 18
Comments on question 7:

Question 7 required significant application of understanding and most candidates made a
good attempt at it.

In part (i) most candidates identified the potential for mis-selling, poor service or poor
investment performance to be driving the problem. Stronger candidates also considered
softer factors including the brand loyalty and media image of the company.

In part (ii) most candidates were able to identify the basic financial issues including the
potential loss on early surrenders and impact on covering fixed expenses. However few
enriched their answer by describing how the charging structure of products may impact on
these issues.

Part (iii) gave candidates the opportunity to think widely about how the situation could be
managed. A number of good examples were given. Weaker candidates lost marks by not
following through ideas from earlier parts of the question, failing to suggest changes for
particular problems they had previously identified. Candidates who were more systematic in
this regard tended to score more highly.


END OF EXAMINERS REPORT
Faculty of Actuaries Institute of Actuaries







EXAMINATION


23 April 2007 (pm)


Subject ST2 Life Insurance
Specialist Technical




Time allowed: Three hours

INSTRUCTIONS TO THE CANDIDATE

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

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 the
supervisor.

4. Mark allocations are shown in brackets.

5. Attempt all 6 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 this
question paper.

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


Faculty of Actuaries
ST2 A2007 Institute of Actuaries
ST2 A20072
1 Describe the principal items that may be deducted when determining the asset share
of a life insurance policy. [5]


2 A life insurance company sells a large volume of unit-linked endowment savings
policies. At maturity the policyholder receives the bid value of the units. On death,
the policyholder receives the bid value of units, subject to a minimum guaranteed
death benefit, as specified in the policy literature. On surrender, the policyholder
receives the bid value of units, subject to a surrender penalty.

The premiums are invested in capital units for the first 5 years of the contract. The
annual management charge is 5% per annum of the bid value of capital units.
Thereafter premiums are invested in accumulation units, where the annual
management charge is 1% per annum of the bid value of accumulation units.

(i) Explain how the company could use actuarial funding to reduce new business
strain on this contract. [4]

(ii) Explain the criteria that must be satisfied in order for the company to be able
to use actuarial funding. [4]

The marketing manager has suggested an alternative product design which specifies a
low allocation rate in the first two years of the contract, with a higher allocation rate
in subsequent years.

(iii) Discuss this suggestion. [5]
[Total 13]


3 A life insurance company sells a wide range of products through insurance
intermediaries. It is about to perform a profit test to assess what premium rates would
be appropriate for its without profits non-linked whole life assurance business.

(i) List the assumptions that would be required to carry out this exercise. [4]

The company is considering performing an analysis of its expenses to determine the
expense assumptions to use in this exercise

(ii) Describe how this analysis would be carried out in order to reach appropriate
assumptions. [15]
[Total 19]



ST2 A20073
4 A young couple are looking for appropriate life insurance. They have just bought
their first house and have two young children. One of them is in paid work, the other
looks after the children.

(i) Explain why a convertible term assurance policy may be the most appropriate
product for this couple. [5]

(ii) Discuss whether you would expect the product to be written on a single life,
joint life payable on the first death, or joint life payable on the second death
basis. [4]

(iii) Discuss the main risks to the life insurance company of writing a convertible
term assurance policy and the ways that the company might mitigate these
risks. [11]
[Total 20]


5 A well established life insurance company, which currently sells a full range of life
insurance products, is seeking to set up a branch in a new territory. Initially it intends
to sell without profits level immediate annuity policies to the local population.

(i) Describe the additional risks to which the company will be exposed when it
sets up the new branch. [13]

(ii) Discuss how these risks can be managed. [8]
[Total 21]


6 A well established life insurance company that sells only with profits business defines
its free asset ratio as (A - L)/L

where A =the value of the assets as reported for supervisory purposes
L =the value of the liabilities as reported for supervisory purposes.

This free asset ratio has been gradually falling over the last three years.

(i) Discuss how the investment strategy of the company may have contributed to
the fall in the free asset ratio. [9]

(ii) Discuss possible courses of action that the company could take to improve its
free asset ratio in both the short and the long term. [13]
[Total 22]


END OF PAPER
Faculty of Actuaries Institute of Actuaries








EXAMINERS REPORT


April 2007


Subject ST2 Life Insurance
Specialist Technical



EXAMINERS REPORT



Introduction

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


M A Stocker
Chairman of the Board of Examiners

J une 2007



Comments

These are given at the beginning of each question.







Faculty of Actuaries
Institute of Actuaries
Subject ST2 (Life Insurance Specialist Technical) April 2007 Examiners Report

Page 2
1 This question was generally well answered. A number of candidates spent time
describing the calculation of asset share, rather than just listing the deductions from
asset share as required by the question.

The cost of any benefits will be deducted. For example this may be the cost of
providing life cover to the extent that any payment made is in excess of the asset share
itself. These may be taken on a smoothed basis or based on actual costs

Expenses will also act to reduce the asset share. These include internal company
expenses (initial/renewal/overheads) and the impact of any commissions payable

The cost of capital set aside in reserves to support the policy may also be deducted

Tax may be deducted from the investment return for some product types

Specific deductions may also be made to cover the actual or expected cost of any
guarantees or options embedded in the contract, for example guaranteed maturity
values.

There may be deductions to make a contribution to free assets to assist in the
smoothing of bonuses or build investment freedom

If the company is proprietary there will also be deductions in respect of profits
payable to shareholders.

Miscellaneous losses e.g. on surrender and losses from without profits business


2 Overall this question was not as well answered as it might have been given that it was
relatively straightforward. In part (i) a number of candidates showed a poor
understanding of actuarial funding. There was a lack of detail in part (ii). In part (iii)
some candidates did not understand that the suggested contract was an alternative to
actuarial funding rather than one on which actuarial funding could be applied.

(i) Actuarial funding allows the life insurance company to hold a lower unit fund
value than if actuarial funding were not used by taking advance credit for the
higher annual management charges

Actuarial funding takes into account, however, that it is not necessary to hold
this fully funded unit value at all points in time, since the unit fund liability is
contingent on certain events.

e.g. the full value of the unit fund is only required to be paid out if the
policyholder dies during the term of the policy.

Only part of the charge applied to capital units is required to cover future
renewal expenses

The remainder is available to create additional capital units to ensure that the
full face value is available by maturity.
Subject ST2 (Life Insurance Specialist Technical) April 2007 Examiners Report
Page 3
Hence at any point in time the company can hold a lower unit fund, defined as:

UF
t


: x t n t
A
+


Where UF
t
represents the fully funded bid value of units at time t..
..and
: x t n t
A
+
represents the actuarial funding factor, where the endowment
assurance function is calculated on a suitable basis.
and n is the original term of the contract

The interest rate used in the calculation of the actuarial funding factor is
usually the difference between the annual management charge charged on the
capital units and the annual management charge charged on the accumulation
units, i.e. in this case 4%.

(ii) The criteria that must be satisfied in order for the company to be able to use
actuarial funding is as follows:

There must be a unit related charge on the unit fund.
This is required so that if less than the fully funded value of units is held
i.e. fewer units are purchased in the early years..
the unit related charge in excess of that used to meet ongoing expenses
will be exactly sufficient to purchase the additional units required in later
years.
Since the charge is unit related, both the unit fund and the charge will
grow at exactly the same rate, the fund growth rate.
Practically, the company must have a product design where in the initial
years, capital units are purchased that have a higher fund management
charge than the fund management charge on the accumulation units bought
in later years.

Strictly speaking, actuarial funding could be used where there are only
accumulation units with an annual management charge of say around 1%
if not all of the 1% is needed to cover future renewal expenses , but in
practice this is not common.

Actuarial funding can be used where the residual charges (from, for
example, annual management charges or policy fees) not used to fund
additional units are sufficient to cover ongoing maintenance expenses

A surrender penalty is needed on the policy if actuarial funding is used.

The surrender penalty will dictate the maximum actuarial funding factor
that can be used, such that the minimum unit fund held at any time equals
the surrender value of the policy.

In addition, the surrender penalty must be defined in terms of a percentage
of the bid value of units.

Subject ST2 (Life Insurance Specialist Technical) April 2007 Examiners Report

Page 4
Actuarial funding must be permitted under the appropriate legislation
The non unit reserve must be sufficient to cover the death benefit available

(iii) The advantage of this product design is that the initial charges taken by the
company (through the low allocation percentages in the first 2 years) could be
set to exactly match the incidence of the high initial expenses suffered by the
company in the first 2 years.

e.g. the company could recoup from these charges the high initial costs of
setting up the policy, including underwriting, paying initial commission,
setting up the non-unit reserves required in the supervisory solvency
regulations and so on.

Contract may be more capital efficient for company (e.g. new business strain
reduced) assuming the reduced allocation in the first 2 years is sufficient to
repay initial costs.

The new proposed design is generally much simpler than one involving capital
units:

The design is more transparent, thus policyholders are likely to find it
easier to understand
Any regulatory requirements for easy to understand contract designs and
no hidden charges are likely to be met
It will also be easy for the sales agents/other sales channels to explain to
potential customers.
No need for two types of units under the new design and all premiums
would be invested in accumulation units with a low annual management
charge

There will no longer be the need to impose surrender penalties, making it
easier for customers to understand and to implement from a system
perspective.
The additional literature that would have been required to explain the
concept of the capital units etc will no longer be required, making
marketing and sales literature more streamlined and customer friendly.

However, the main disadvantage of this approach is that, as a result of the
product design being very transparent, potential customers may view the
initial charges as too high and difficult to justify and hence they may not
find this product attractive.
This is especially true in relation to alternative forms of investment that may
be available, such as investment in mutual funds/unit trusts where the
allocation rates would be much higher.
Hence customers may in this instance choose to invest in unit trusts directly
and purchase the insurance cover separately (e.g. via a term assurance
product) rather than suffer these heavy up front fees.
There will now be two different designs of the contract resulting in legacy
systems and products that need maintaining.
Subject ST2 (Life Insurance Specialist Technical) April 2007 Examiners Report
Page 5
Systems implications need to be considered whilst there is now no need for
capital units, there is a requirement to include reduced allocation rates for
certain periods
The actions of competitors would need to be taken into account capital
units may no longer be offered by other companies.
There is a need to consider the extra costs of developing the new product
design e.g. costs of additional training of staff and additional profit testing
required


3 This question was heavily based on bookwork and was generally well answered. In
part (ii) candidates concentrated on the splitting up of expenses, and there was
relatively little discussion around the conversion of these expenses into expense
allowances.

(i) List of assumptions required:

Mortality
Initial administration expenses
Ongoing administration expenses
Claim expenses
Investment expenses
Expense inflation
Initial commission
Renewal commission
Clawback of commission
Surrender/Paid Up rates
Investment return
Tax
Reserving requirements
Solvency margin requirements
Rate of re-insurance recovery
Profit criteria e.g. IRR
Or profit margin at specified risk discount rate
Average case size
Volumes of business
Business mix,
e.g. age / sex etc

(ii) The company would need to agree the period to which expense analysis will
relate.

It would want the period to be short enough to ensure homogeneous data but long
enough to enable it to have sufficient data such that results are credible.
It would need to gather data subdivided into:

Direct expenses: Expenses that depend on volume of NB or level of in force

Overheads: Balance of expenses e.g. those that relate to general management and
service departments not directly involved in NB or policy servicing
Subject ST2 (Life Insurance Specialist Technical) April 2007 Examiners Report

Page 6
In addition the company would want to split expenses into initial, renewal,
termination and investment expenses

The company would also want to split expenses between single and regular
premium policies

The company would also want to split expenses into those that are per policy, per
premium or per sum assured

Commission would be excluded from the investigation and allowed for as paid

The main costs are likely to be Salary and Salary related

Such expenses would be split by department/function.

The company would need to identify those departments that are directly involved
in servicing policies, and those that are overheads

Those departments that are obviously linked to non linked whole life can be
allocated to that product line

Those obviously linked to other product lines can be ignored

It would need to split time by process undertaken e.g. policy servicing, policy set
up or claim settlement

Where a function works on a variety of processes/products then the expenses can
be split using a timesheet analysis

Those departments that are identified as pure overheads (e.g. HR, Legal,
Accounting, Actuarial Valuation) can be split pragmatically across other
Departments e.g. HR could be split in proportion to number of staff in each direct
area.

Underwriting costs

There may be costs relating to the companys underwriting process, for example
the cost of doctors reports or medical examinations
These would be directly allocated to new business

Property Costs

Property costs that relate to buildings occupied by the life company can be split by
using notional rents and then allocating by floor space occupied by departments,
and then expenses allocated as per salaries above

Computer Costs

Allocate to departments by computer usage

Costs of purchasing new computers could be amortised over useful lifetime
and then added to ongoing computer costs
Subject ST2 (Life Insurance Specialist Technical) April 2007 Examiners Report
Page 7
Investment Costs

Directly allocated to investment expenses
Split directly by product line based on funds under management

One off capital costs

Any relevant costs would be amortised over expected useful lifetime and treated
as part of overheads and spread by department
Exceptional Items that are unlikely to recur will be excluded from the analysis

Expenses would need to be inflated from the period of investigation to the period
for which they will be used
They may also be adjusted for any known changes in expense levels, e.g. benefits
from recent cost saving programmes
These would then need to be converted into allowances per policy using:

Number of new policies for new business expenses
Average number of policies in force over analysis period (for renewal
expenses) Average number of claims over analysis period (for termination
expenses)
Investment expenses are likely to be expressed as a percentage of funds
under management so that they can be treated as a deduction from earned
investment return.

The company would then want to compare its resulting assumptions to those
derived from previous exercises and ensure that it understands any significant
variations
The company may then want to include prudent margins within the allowances


4 Whilst part (i) was generally well answered, many candidates only discussed the
merits of convertible term assurance rather than discuss why other products may not
be appropriate. In part (ii) a significant number of candidates did not demonstrate an
understanding of the relative costs of the different options; those that did understand
this tended to perform better. A lack of detail within the answers to part (iii) tended to
cause candidates to score poorly on this.

(i) At this point in their life, their main need would be to provide for the financial
needs of the family in the event of the death of one or other of the parents.

Primarily, it is the death of the salary earner that would cause the greatest
financial hardship to the family.

Given that they have just moved into their first house and have young
children, their disposable income is likely to be low.

This means that investment products are unlikely to be their highest priority.

Subject ST2 (Life Insurance Specialist Technical) April 2007 Examiners Report

Page 8
This means that an endowment assurance or whole of life assurance are likely
to be an unnecessary expense for them at present.

The same could be said for pensions, although the salary earner may be part of
a company pension arrangement.

A term assurance is, therefore, likely to provide the financial protection that
they need at a cost they are likely to be able to afford.

A decreasing term assurance may be appropriate if they are only concerned
with repaying any loan/mortgage they have taken to out to buy the house.

However, a level term assurance is more likely to be required to enable the
surviving parent to be financially secure, even after the loan has been repaid.

One of the risks that the couple will take is the risk of inflation.

The benefit payable by the policy may not be sufficient at the time it is paid
due to the effects of inflation.

The convertible term assurance gives the couple an option to effect a further
policy without underwriting at the end of the original term assurance.

This would enable them to effect a larger policy in the future, hence mitigating
the inflation risk, when their disposable income may be greater, irrespective of
their state of health.

The convertible term assurance is flexible if the needs of the couple change in
future.

Alternatively, they could effect a with profits endowment or whole of life. The
benefits from these policies would increase as bonuses are declared, giving
some protection against inflation.

(ii) Joint Life First Death

J oint Life First Death provides the most cover and meets the needs of the
couple.

This provides benefit to help fill the need if the salary earner dies.

But also provides benefit to help pay for childcare should the other parent die.

However, for a given level of benefit this is the most expensive option.

Single Life

They may choose to compromise and select the single life option on the life of
the salary earner.

Subject ST2 (Life Insurance Specialist Technical) April 2007 Examiners Report
Page 9
Or they may select a lower benefit and the joint life first death option.

This will depend on their circumstances (for example, if their parents live near
by, they might be prepared to help with childcare).

Also, the decision may be affected by whether the salary earner is part of a
group life cover arrangement provided by the employer.

Joint Life Last Survivor

The low cost option would be joint life payable on the second death.

Whilst the size of the premium might be crucial, this basis for the life cover is
unlikely to meet the familys financial needs if the salary earner was the first
to die.

Although, this might be deemed acceptable if the other parent expects to
return to work in the very near future.

(iii) Mortality

The major risk is that the experienced level of mortality of the lives covered
by this contract is significantly worse than assumed when pricing the product.

This could be exacerbated if the mortality of those with abnormally large sums
assured was worse.

There is a risk that the loading for the convertibility option is insufficient to
meet the cost of the option.

There is scope for anti-selection by the policyholder both at the start of the
policy and at the time of conversion.

The two main ways to mitigate theses risks are underwriting and reinsurance.

Underwriting ensures that the health of potential customers is, across the
portfolio, in line with that assumed in the pricing. Underwriting would need to
take into consideration mortality after the conversion date, so over a longer
period than the original term.

Reinsurance would protect the company from general mortality risks. Either
by reinsuring all lives to some extent or by reinsuring the large cases.

The pricing for conversion options is difficult; advice from the reinsurance
company should be sought.

Reinsurance introduces a further risk, that the reinsurer defaults, which can be
mitigated by carrying out due diligence on the credit rating and financial
standing of the reinsure, or by using more than one reinsurer.

Subject ST2 (Life Insurance Specialist Technical) April 2007 Examiners Report

Page 10
The risks associated with the conversion option can be further mitigated by
limiting the conversion options to specific events or to specific times

Expenses

There is a risk that future levels of expenses (renewal and termination) and
expense inflation may be higher than assumed in the pricing.

Levels of commission and initial costs should be reasonably predictable, if
sales volumes are in line with plan.

Rigorous cost control should be pursued and monitored regularly.

Action should be taken as soon as they move significantly from the assumed
level.

Withdrawal

The company is at risk from early withdrawal, as premiums are unlikely to
have covered the initial costs, and from selective withdrawals.

A prudent allowance for withdrawals should be assumed in the pricing.
The key to this is to ensure that the product is appropriate for the customers
and is affordable.

The sales process should be checked to ensure that these issues are addressed,
and commission clawback processes can be introduced to encourage
intermediaries to check affordability and need of product at outset.

Withdrawal experience should be monitored and re-price if significantly worse
than assumed.
When introducing new rates, there is always the risk of lapse and re-entry if
rates are cut.

In practice there is not much that can be done. If it is expected to be
significant, then any expected loss arising from the lapsing policies would
need to be offset potential profit from sales in the decision process.

Mix of business

If the mix of business is significantly different from the model points used to
profit test the rates, then any cross-subsidies between rates for different ages
and terms will lead to a different level of profit.

Volume of Business

Too much business leads to excessive new business strain and capital
problems or admin capacity issues.

Subject ST2 (Life Insurance Specialist Technical) April 2007 Examiners Report
Page 11
Need to carefully monitor actual volumes against plan to ensure remain within
acceptable limits.

Too little new business could mean that the Company doesnt recoup
development costs.

Need to carry out market research pre-launch to ensure that appropriate
demand exists.

In general, the risk of profit being less than target could be reduced by
increasing any margins in the premiums charged .

Other general risks e.g. regulatory, tax, competition


5 This question was not as well answered as expected by the examiners. In many cases
candidates described all risks of writing annuities, rather than concentrating on the
additional risks of writing annuities in a new territory. Many candidates failed to
mention the requirement to understand the market and competition. Answers were
often highlighting an issue without demonstrating a real understanding of the
difficulties the insurer would face.

(i) Legal/Regulatory

The insurer may have lack of knowledge of local legal framework or a
lack of knowledge of life insurance regulations
The insurer would need to consider potential taxation issues (e.g.
withholding tax)
It would also need to consider possible capital requirements it may be
required to hold resources in local currency/assets
It would need to consider different political risks e.g. government may
have monopoly and discourage new entrants

Data

The insurer will not have any data initially on which to base current
assumptions,
It will need to ensure sufficient data collected when contracts written
There may be legal barriers to asking for certain data


Mortality/Longevity

There may be a lack of data on past local mortality experience or a lack of
data on which to adequately reflect future mortality improvement trends
There might be different types of mortality risk or more volatile mortality
than in the current territory
The level of medical advancements within territory will impact longevity

Subject ST2 (Life Insurance Specialist Technical) April 2007 Examiners Report

Page 12
Expenses

The company is exposed to local inflation (assuming staff are employed in
local branch); these may be higher than normal (e.g. due to higher admin
costs)

There may need to set up new distribution arrangements which may be
expensive

There may be limited pool of skilled employees may lead to employer
having to buy people in at higher salaries
Given the limited knowledge of the territory, estimates of development
costs and new business volumes may be less certain, increasing the risk
that development costs are not recouped

Systems

There may be a lack of system infrastructure
The company will need to consider whether its current administration
systems cope

Competition/Market

There may be a lack of knowledge of local market who are competitors
- and no brand currently in territory
There may be insufficient demand for this product. For example, is the
state benefit/pension adequate such that market for annuities doesnt exist
The company will need to consider how competitive the market is and
consumer attitude to foreign companies

New Business

The company will need to assess mix/size of new business ; there is a risk
that it does not do this accurately given its lack of experience in the market
It will also need to understand distribution systems in new territory

Investment

The company may require capital resources within territory which may be
of relatively low credit rating or of limited availability
There may be a currency risk arising from mismatching of assets and
liabilities or a currency risk on repatriation of profits to parent company
There may not be suitable assets in territory to back liability e.g.
insufficient fixed interest stocks of suitable term

Fraud

It may not be possible to verify that annuitants are alive

Subject ST2 (Life Insurance Specialist Technical) April 2007 Examiners Report
Page 13
Other

reinsurance may not be available or very expensive; or it may only be
available from low credit rated reinsurers
The company may not able to find suitably experienced staff &
management
There may be practical issues and risks around language and time
differences.

(ii) Market/Competition

There is a need to ensure that market research is conducted to gather suitable
information on the local regulations
and market.

This could be done by gathering information from the local market using
publicly available info, regulatory returns, reinsurers ,or
auditors/consultants/local experts

There is a need to ensure that the brand and company are suitably promoted
prior to launch in the territory, and that product design is suitably innovative

Data

Data regarding mortality and trends may be more difficult.

Reinsurers should be able to assist, although regulatory returns may detail
reserving and/or pricing bases

Assumptions

In pricing the product the company needs to build in prudent margins for all
assumptions notably mortality improvements and expense inflation

The company will want to project cashflows from the business using various
scenarios to indicate the sensitivity of the profit to key assumptions.

Mortality

The company could mitigate mortality risk by writing other products in the
territory for which profits would increase if people lived longer (e.g. term
assurance)

It May make use of reinsurance if available. This would limit risk to insurer
initially

It could spread across more than one reinsurer or use highly rated reinsurer

It will need to regularly review experience of this branch to assess if mortality
experience is as assumed
Subject ST2 (Life Insurance Specialist Technical) April 2007 Examiners Report

Page 14
Expenses

It should maintain a strict budget and monitor expenses closely against this.

It could hedge expense inflation using local index linked bonds if available

Systems

The administration systems would probably use the main administration
systems of the home country thus avoiding excessive expense of new
systems, and also benefiting from all controls already built in.

Investments

To avoid currency mismatch there is a need to invest in assets that match the
currency (as well as the term) of the liabilities.

To reduce currency risk in repatriation of profits it could use derivatives

New Business

It will want to build in various new business scenarios, including different
volumes and mixes of business

It could use local intermediaries or set up a partnership with an existing
company in that territory (e.g. for distribution)

It may require a higher return on capital or charge higher premiums to manage
risks

It should monitor sales regularly and act quickly on any noticeable trends

Other

It needs to build in processes to verify annuitants are still alive

If risks were deemed unacceptable by the company then it could decide not to
proceed with the project.

Subject ST2 (Life Insurance Specialist Technical) April 2007 Examiners Report
Page 15
6 This was felt to be the hardest question in the paper and was relatively poorly
answered. There was a lack of detail in candidates solutions in part (i), especially in
explaining the impact of a movement in yields on particular assets and the expected
impact on liabilities. In addition many candidates included reasons in part (i) that
were not investment strategy related (e.g. bonus declarations, new business volumes,
expenses, regulatory changes). In part (ii) many candidates failed to separate out the
short and long term options, which was asked for in the question.

(i) Factors that may have contributed to the fall in the free asset ratio include:

The life insurance company may have been holding a mismatched investment
position, where the assets held by the company did not match the liabilities of
the company, either by nature, term/duration and/or currency. As a result of
this the company may have had to increase reserves by holding a significant
mismatch reserve

The impact of this would be that the value of the assets of the life insurance
company and the value of the liabilities of the life insurance company do not
change in the same way (either in direction or in magnitude) as a result of, say
a fall in value of a particular asset class.

For example, the company may have been holding a proportion of its assets
denominated in overseas currencies (e.g. by investing in overseas bonds or
overseas equities), which may have fallen in value, whilst the liabilities that
these assets were backing may have been denominated in a different currency
and hence, the value of the liabilities may not have fallen.

The fixed interest assets held may have had a shorter duration than the
liabilities. If the yields on fixed interest assets fell, this would mean that the
liabilities would increase by more than the assets (or vice versa)
If the yields on fixed interest assets decreased in the last three years, this is
likely to have led to a reduction in the valuation rate used to value the
guaranteed liabilities of the life insurance company. This would increase the
liabilities.

So, even if the assets increased by the same amount, the free asset ratio would
reduce

If valuation yield is based on yield of equities then there may have been a
reduction in this yield, causing liabilities to increase and reducing the ratio

This reduction in valuation yield may have been caused by a fall in dividends
or earnings, in which case asset values would be unaffected and there would
be no change to the top line in the ratio and the ratio would fall. It may have
been caused by a rise in equity values without a corresponding increase in
dividends and earnings, in which case the ratio would be less likely to fall


Subject ST2 (Life Insurance Specialist Technical) April 2007 Examiners Report

Page 16
The company may not have been holding a sufficiently high proportion of
fixed interest assets to meet all of the guaranteed benefits for with profits
business.

For example, the company may have been holding a large proportion of its
assets (including any free assets) in real assets such as equities.

Equities have volatile values and may have fallen in value in the last few
years, whilst the value of the liabilities that the equities are backing may not
have fallen.

This is because, although the running yield on equities would have increased
thereby reducing the liabilities, the impact on liabilities may have been less
than the fall in asset values

The company may have been taking deliberate action to improve its asset-
liability matching and may have been gradually switching more of its assets
into fixed interest type assets as opposed to those offering real returns. This
may have resulted in the company making lower investment returns which are
insufficient to cover new business strain

The company may have been holding assets that were not admissible under
supervisory solvency calculations, and the relative value of these may have
risen resulting in a fall in the free asset ratio

The company may be subject to regulatory requirements that limit the value of
certain assets e.g. to book value, rather than full market value

The company may have just experienced poor investment performance on its
free assets possibly including a high number of defaults on corporate bonds,
and falls in the value of properties held

(ii) There are several courses of action that the company could take to improve its
free asset ratio further both in the short term and long term.

Shorter Term

The company could improve its free asset ratio by reviewing the assumptions
used in the valuation basis.

Overall the assumptions may be too prudent/cautious and it may be possible to
weaken the valuation basis to improve the free asset ratio.

The actuarial team would consider the recent experience of the company with
regards to mortality, morbidity, lapses and expenses etc., to determine whether
a weakening of the valuation basis can be justified.

They would also need to consider the expectations of the regulator and the
with profits policyholders, with regards to changes in the valuation basis and
Subject ST2 (Life Insurance Specialist Technical) April 2007 Examiners Report
Page 17
the need for continuity from one valuation to the next without arbitrary
changes.

The company could also improve its free asset ratio by taking actions such as
cutting back on capital investment in new projects (e.g. new product
development) or in reviewing the efficiency of particular distribution channels.

Investment in the less profitable channels could be reduced or in the extreme
particular distribution channels could be discontinued (this should also be
beneficial in the long term)

One of the simplest ways to enhance the free asset ratio of the company would
be to either require the existing shareholders to inject capital into the company
or to raise capital through securitisation or selling off blocks of business.
Alternatively, the company could consider using financial reinsurance to
reduce regulatory liabilities without having to make a corresponding reduction
in the assets. However, raising capital just to enhance the free asset position, is
unlikely to be viewed well by the market.

The company should ensure the level of assets that are not allowed for
regulatory purposes (inadmissible assets) is kept to a minimum

The company could change its asset mix so that it invests in assets that
increase the valuation yield

The company could move to a position that better matched assets and
liabilities if this reduced any mis-matching reserve that is required to be held

Longer Term

If the company is currently not holding a well matched asset liability position,
and it is thought that this has led to the erosion of the free asset ratio in the last
three years, then the actuarial team could investigate the impact of moving to a
more matched asset liability position and whether this would improve the free
asset ratio. This will reduce the risk of a further erosion due to any mismatch

They would need to consider:

The asset allocation required given the nature/term/currency of the
liabilities.

Whether a forced reallocation over a short period of time could result in
the sale of equities at a time when equity values are thought to be low
resulting in realised capital losses, hence the practical timing of when the
move to the new asset allocation can be achieved would need to be taken
into account.

There may also be tax implications that the company would need to
consider.

Subject ST2 (Life Insurance Specialist Technical) April 2007 Examiners Report

Page 18
The implications of switching to a more matched position, from a
regulatory perspective.

The company may actually be holding too high a proportion of its assets in
fixed interest type securities, and hence the company may not be sufficiently
exposed to real assets offering a better rate of investment return in the long
run.

Hence moving assets into asset classes offering greater levels of investment
return may result in an improved free asset ratio over time.

This is especially true if the free assets of the company are being held in too
conservative an asset class (e.g. could move to a less well matched position)

Similarly, the company may need to review its investment guidelines, since
previous guidelines may have prevented investment in certain asset classes,
such as property, which may actually offer good potential for long term
investment returns.

Switching into such asset classes may lead to better investment returns and
improvements in the free asset position in the long run, although care would
have to be taken to ensure compliance with local investment regulations.

The company could also improve its free asset ratio by finding other ways to
reduce expenses this may be, for example, introducing more IT to improve
the efficiency of operational processes, introducing a cost cutting programme
to identify obsolete roles resulting in redundancies or identifying areas where
costs can be saved e.g. property costs.

Reducing expected future expenses could have an immediate benefit through a
reduction in expense reserves

In the longer term the company may be able to improve its free asset ratio by
introducing new more profitable lines of business or reduce new business in
less capital intensive products

An overall reduction in new business, or closure to new business, will improve
the free asset ratio in the longer term

The company could consider reducing bonuses, or deferring bonuses, where
appropriate, and where in line with treating customers fairly.


END OF EXAMINERS REPORT
Faculty of Actuaries Institute of Actuaries







EXAMINATION


4 October 2007 (pm)


Subject ST2 Life Insurance
Specialist Technical




Time allowed: Three hours

INSTRUCTIONS TO THE CANDIDATE

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

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 the
supervisor.

4. Mark allocations are shown in brackets.

5. Attempt all 6 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 this
question paper.

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


Faculty of Actuaries
ST2 S2007 Institute of Actuaries
ST2 S20072
1 Describe how a mutual life insurance company might use a model to develop an
appropriate investment strategy for its in-force with profits business. [6]


2 (i) Describe how a life insurance company would analyse its withdrawal
experience. [6]

A large proprietary life insurance company has been selling unitised with profits
endowment assurances successfully for a number of years. Premiums for these
policies are paid monthly by direct debit, and may be increased or decreased at any
time. The policyholder can stop premium payments temporarily for a period of up to
12 months. After this period, the policyholder can choose to re-instate premiums,
have the policy made paid-up, or surrender the policy.

To date the companys analysis of withdrawals only takes account of surrenders. The
company is considering extending its withdrawal experience analysis to achieve a
better understanding of the surpluses arising.

(ii) Discuss this suggestion. [6]
[Total 12]


3 A life insurance company has for many years sold policies through its own sales force
and through press advertising.

(i) Describe the main features of the companys existing sales channels. [6]

The company is looking for alternative distribution channels in order to increase sales
growth. It is considering both:

(a) insurance intermediaries
(b) telephone sales

(ii) Discuss how the proposed channels might achieve the companys aim. [9]
[Total 15]


ST2 S20073 PLEASE TURN OVER
4 A man purchased a without profits endowment assurance with a 25 year term on his
40
th
birthday. The sum assured of 50,000 is payable at maturity, or at the end of the
year of death if earlier. He pays a premium of 1,000 annually in advance.

He has just reached his 50
th
birthday and has not yet paid the premium due at that
date. He has decided that he no longer wishes to use this type of policy for the
purpose of savings and would prefer to invest directly in equities. He has therefore
requested a calculation of the surrender value and paid-up sum assured for his policy.

The insurance company calculates surrender values using a prospective calculation
method. Paid-up sums assured are based on an equation of value using the surrender
value as the current policy value. The following assumptions are used:

Mortality AM92 Ult
Interest rate 6.0% p.a.
Renewal expense 35 per annum for premium-paying policies
20 per annum for paid-up policies
Renewal expense inflation 1.92% p.a.
Claims expense 0.5% of benefit on death and maturity
Alteration expense 100 on surrender and alteration

(i) Calculate the surrender value to which the policyholder would be entitled. [7]

(ii) Calculate the paid-up sum assured to which he would alternatively be entitled.
[5]

(iii) Discuss the other key issues that the policyholder should consider before
making a decision. [5]
[Total 17]


5 A life insurance company is repricing its term assurance product. For new policies, it
is considering adding an option under which policyholders may renew the policy at
the end of its original term without providing additional evidence of health.

(i) Explain why a cashflow approach would normally be preferable to a formula
approach to price this product. [4]

(ii) Describe how in practice you would use a deterministic model to price this
product. [14]

(iii) Discuss whether it would be appropriate to use a stochastic approach to price
this product. [3]

(iv) Discuss the other considerations that the company should take into account
before adding the option. [6]
[Total 27]

ST2 S20074
6 For many years a non-European life insurance company has been selling large
volumes of a single premium unit-linked product that has the following design:

Term 15 years
Allocation rate 95%
Fund management charge 1.0% p.a.
Maturity benefit Value of unit fund plus maturity bonus
Surrender benefit 90% of value of unit fund
Death benefit Higher of premium paid and value of unit fund

The maturity bonus is only paid if the policy is still in force on the maturity date, and
is calculated as a percentage of the value of unit fund at that date. The percentage is
determined by the company according to an unpublished formula and is dependent on
the performance of the unit-linked funds over the 15 year period. It has a guaranteed
minimum of zero. Over the past ten years it has on average been 2%, but it has varied
between 0% and 5%.

When the product was launched, the valuation actuary decided to adopt a simplified
approach in order to calculate the statutory reserves for this product. In particular, he
wanted to use an approach that would not require any explicit assumptions. He
therefore decided to calculate the reserves as the higher of the current value of the unit
fund and the original premium.

A colleague of the valuation actuary has now informed him that the Groupe
Consultatif des Associations dActuaires des Pays des Communauts Europennes
has proposed a set of principles for setting reserves. The colleague has asked whether
the valuation actuarys approach is consistent with these principles.

(i) State which of the proposed principles for setting reserves would be applicable
to the simplified method currently used to value the product. [6]

(ii) Discuss the extent to which the valuation actuarys approach meets each of the
principles identified in your answer to part (i). [17]
[Total 23]


END OF PAPER
Faculty of Actuaries Institute of Actuaries








EXAMINATION


September 2007


Subject ST2 Life Insurance
Specialist Technical


EXAMINERS REPORT



Introduction

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


M A Stocker
Chairman of the Board of Examiners

December 2007


Comments

Comments on individual questions are given in the solutions that follow.










Faculty of Actuaries
Institute of Actuaries
Subject ST2 (Life Insurance Specialist Technical) September 2007 Examiners Report

Page 2
1 The business will need to be split into appropriate model points that represent the in
force portfolio. The liabilities and assets would then be projected forward on
assumptions that represent expected future experience, although the company will
also want to consider the effect of variations from these.

For the assets, stochastic investment models can be incorporated in order to project
future investment income and changes in capital values.

The projected supervisory liabilities and assets can be valued at the end of each year.
The liabilities need to take into account future bonuses and these should be
dynamically linked to reflect actual practice in terms of bonus setting

The excess of asset over liabilities needs to be sufficient to cover comfortably the
level of solvency required by the company, which itself may depend on the
investment strategy (i.e. the liabilities should by dynamically linked to the investment
strategy). What is comfortable will depend on any regulatory requirements, the
nature of the business, and the level of cover provided by other companies.

The above can be used to produce a statistical distribution of the amounts available
each year to cover the level of solvency capital required. From this, the probability of
potential future insolvency can be estimated given a particular investment strategy.

The simulations could also be used to determine the level of free assets the company
needs in order to support a particular investment strategy and keep the probability of
insolvency below an acceptability low figure. If the probability of insolvency is
considered too high, then new investment strategies will need to be modelled.

Stronger candidates scored very well on question 1. However a large number of students
spent too long describing the investigations behind assumptions used in the model. This was
not required by the question. Such candidates scored badly as they tended not to spend long
enough describing how the model could be used.


2 (i) The factors by which the data could be analysed are as follows:

Duration in force withdrawals rates are generally higher near the start of
the contract, but this will depend on any point guarantees or surrender
penalties on the contract.

Target market the degree of care taken ensuring that a suitable product is
sold may depend on the target market. The more suitable the product, the
lower the withdrawal experience.

The size of premium and original term of contract would also be considered

The data would also be split by sales channel and advisor. Customer data
would also be split by sex and age as experience tends to be worse for females
and for younger ages.

Subject ST2 (Life Insurance Specialist Technical) September 2007 Examiners Report
Page 3
The process the company would use is to first split the data into the above
homogenous groups. The number of contracts issued in the last financial year
is then divided into the corresponding number that survive in force until the
first policy anniversary to give a first year persistency rate.

The first year withdrawal rate can be determined as one less the persistency
rate. Alternatively look at the number of withdrawals divided by the exposed
to risk. Deaths and maturities should be excluded from the investigation (if
material). A similar process can be adopted to obtain the second year, third
year etc. withdrawal rates.

(ii) Other investigations the company might do include the following:

The companys profits will be sensitive to policies being made paid-up and to
premiums being reduced, as well as to withdrawal rates. An analysis of
policies that are made paid-up could be done as a subsidiary part of the
withdrawal analysis.

One issue that the company faces is to determine when the policy was made
paid-up since the premiums can stop for 12 months before becoming paid-up.

An analysis of premium reductions could also be performed. However this
could require data which is not readily available. Also there is the issue that
someone may be reducing a premium back to a previous level after a recent
increase and so a decision should be made as to whether this really constitutes
a reduction. In addition some people may make one off payments, and
reverting back to their normal monthly level should not constitute a reduction
in the premium

An analysis of premium holidays could also be performed, but again there are
difficulties with this. Data as to the duration of the premium holiday would
also be required.

Generic problems with the above are that low levels of data could mean results
are spurious. These analyses will however be important in understanding the
analysis of surplus and its limitations. The results may also help with setting
pricing assumptions and reserving assumptions.

The benefits of extending the analysis should be estimated to ensure that they
justify the cost.

Part i was mostly well answered. Most candidates were able to describe the
methodology in detail, giving good examples of how data would be subdivided.

Most candidates struggled with part ii. Some were able to demonstrate an
understanding of the financial impacts of the different decrement types but few
showed an understanding of the practical difficulties associated with analysing them.



Subject ST2 (Life Insurance Specialist Technical) September 2007 Examiners Report

Page 4
3 (i) Own sales force:

The sales force are employees of the life insurance company. They are paid
either by commission or salary. Most often it is a combination of the two.

Typically, the sales person will initiate the sale by using client lists. Client lists
can be purchased, but they may also have been obtained from replies to the
press adverts.

A successful sales person will be able to develop a long-standing relationship
with their client. Ultimately, the client will approach the sales person for new
products, as a trusted source of advice.

The products offered through this channel will depend heavily on the target
market, which in turn will depend upon the client lists and the publications
where the company adverts are placed. Typically, the market is not particularly
financially sophisticated (but this need not be the case). As a result the
products offered are typically more simple.

For this channel to be successful, a broad range of products needs to be
offered unless the target market is very specific.

Press Advertising:

If the company uses this channel as a sales channel in its own right, then the
products have to be very simple.

The publications chosen to carry the adverts will be targeted towards the
chosen market so that there is a higher chance of uptake.

Alternatively, the advertising could promote the services of the sales force.

(ii) (a) Insurance intermediaries:

This would be quite a departure from the existing channels.

Insurance intermediaries compare products across the market place and
seek to find the best option for their clients. This will lead to a degree
of competition with other life companies that the company is not
currently exposed to. Products will, therefore, need to be competitive
to meet the desired sales growth.

Also, this market place tends to be at the more sophisticated end of the
spectrum. The products that the company currently sells may not suit
this market place. However, as this is a very different market, if the
company is successful, the opportunity for sales growth is probably
greatest.

Subject ST2 (Life Insurance Specialist Technical) September 2007 Examiners Report
Page 5
There may be conflict with the Direct Sales Force leading to lower
sales in that channel. So increased sales in this channel may have to be
offset against falls in existing channels.

(b) Telephone sales

This might fit well with the existing channels

This could areas of the country that it is uneconomic to cover with
sales people. Or it might used where the expected sales might be of
lower value and so might not justify a face to face visit. So sales could
increased through increased exposure to customers not covered by the
Direct Sales Force.

It is not obvious that this will be a lower cost distribution channel than
face to face. Whilst telephone sales people will spend more time
speaking to more clients, as they do not have to travel, the success rate
of those interviews may be less than face to face.

The existence of a call centre gives extra options for the press
advertising including:

Advice on the advertised product, increasing total sales

Providing alternative products if the advertised product was
unsuitable

Deciding whether a face to face visit is justified.

Again, this will lead to additional sales compared to existing channels.

Answers to question 3 were mixed. Generally candidates described the key
features of the channels in part i but many did not give enough detail to score
well.

In part ii stronger candidates gave a good range of points regarding how the
new channels may compliment the existing as well as describing some of the
challenges associated with these channels. Some candidates spent time
describing the general features of the new channels, rather than discussing
how they might help achieve the aim of increasing sales growth.


Subject ST2 (Life Insurance Specialist Technical) September 2007 Examiners Report

Page 6
4 (i) Surrender value =Present value of {Benefits +Claims expenses
+Renewal expenses Premiums} Alteration expense

Present value of benefits =50,000 *
50:15
A at 6% p.a.
=50,000 * 0.43181
=21,590.5

Present value of claims expenses =0.5% of present value of benefits
=0.005 * 21,590.5 =108.0

Expense inflation =1.92% p.a.

Since 1.0192/1.06 =1/1.04, can use annuity factor at 4% p.a. to allow for
future inflation of renewal expenses.

Assume renewal expenses are incurred annually in advance, in line with
premium payments.

Present value of renewal expenses =35 *
50:15
a

at 4% p.a.
=35 * 11.253
=393.9

Present value of premiums =1,000 *
50:15
a at 6% p.a.
=1,000 * 10.038
=10,038.0

Alteration expense =100

So surrender value =21,590.5 +108.0 +393.9 10,038.0 100.0
=11,954.4


(ii) Let the paid-up sum assured be denoted PUSA.

This is then calculated from:

Surrender value =Present value of {Paid-up benefits +
Paid-up claims expenses +Paid-up renewal expenses}

Present value of paid-up benefits =PUSA * A
50:15
at 6% p.a.

=PUSA * 0.43181

Present value of paid-up claims expenses =0.005 * PUSA * 0.43181

Present value of paid-up renewal expenses =20 * a
50:15
at 4% p.a.
=20 * 11.253
=225.1

Subject ST2 (Life Insurance Specialist Technical) September 2007 Examiners Report
Page 7
Surrender value from part (i) =11,954.4

So:

11,954.4 =PUSA * 0.43181 * 1.005 +225.1
PUSA ={11,954.4 225.1}/{1.005 * 0.43181}
=27,028.0

(iii) The change in risk exposure should be considered:

The maturity benefit under this policy is guaranteed whereas the value of
equity shares is volatile. This risk is increased if the equities purchased are not
well diversified. This means that there is greater downside risk if investing in
shares. But there is also greater upside potential.

If the policyholder decides to surrender the policy and invest the proceeds into
equities then he loses the whole guarantee. If he decides to make the policy
paid-up and invest future premiums into equities then he retains part of the
guarantee.

The policyholder therefore needs to take into account his attitude to risk.

The change in protection cover should be considered:

This policy is not just a savings policy, it is also a protection policy: the death
benefit is considerably higher than the surrender value. If the policyholder
decides to surrender the policy then he loses this extra death benefit cover. If
he makes the policy paid-up then it reduces significantly.

Depending on his personal circumstances, this protection might be important.

Other issue to consider:

It will be necessary to consider the tax implications of the surrender and
investment in equities.

Stronger candidates scored well on question 4 getting full marks on parts i and
ii. However a number of candidates did not use the correct formulae and
consequently lost marks.

Many candidates made a good attempt at part iii showing a good
understanding of the product by highlighting differences in return potential
and impacts from losing the protection element of the contract.



Subject ST2 (Life Insurance Specialist Technical) September 2007 Examiners Report

Page 8
5 (i) A cashflow approach would normally be preferable to a formula approach
because:

It enables a company to measure the expected return than the providers of
capital will receive.

The sensitivity of profit to variations in experience can be investigated so as to
determine appropriate margins for the parameter values.

Reserves and solvency requirements can be explicitly allowed for.

The cashflows can be used to assess the financing requirements for new
business by incorporating these cashflows into the in force model to see the
impact of the financing requirements on the company as a whole.

It allows more easily for lapses and surrenders.

The anti-selection effect of the option can more easily be allowed for.

It is easier to incorporate assumptions that very over time, including stochastic
assumptions.

The risk discount rate can take account of the term structure of interest rates,
although this may not be significant for this contract due to the low reserves.

Tax can be allowed for more appropriately.

(ii) Firstly, determine a set of model points which represent the expected new
business based on the profile of the existing business allowing for any
expected changes in the profile.

For each model point project the cashflows allowing for projected solvency
and reserving requirements. Use best estimate assumptions for mortality,
withdrawals, expenses, investment returns and tax

Calculate the cost at the end of the projection period of the cost of the option.
Could use either North American or Conventional Method

Need to make assumptions regarding mortality at the end of current term,
and also take-up rates. If assume higher take up rate, then mortality may revert
to average mortality over time. But if assume lower take up, then should have
higher mortality assumption for renewal option as it is likely that those with
lower life expectancy will take it up.

It is likely that the charge for the option will be a % of premium the
company needs to assess this against competitors and consider whether it is
marketable. The cost will also need to be assessed against standard term
assurance rates

Subject ST2 (Life Insurance Specialist Technical) September 2007 Examiners Report
Page 9
The company should discount the cashflows at a risk discount rate that reflects
the return required by the company and the level of statistical risk attached to
the cashflows (i.e. the variation around the mean as represented by the
cashflows themselves).

The premiums can be set so that the company achieves its required profit
target.

The premiums need to be considered for marketability. This may lead to
reconsideration of the design of the product (e.g. the removal of option or the
addition of features to differentiate this product from its competitors). The
distribution channel which may either permit lower expenses to be used, or
higher premiums to be charged without it affecting the marketability may also
be reconsidered

The company may also reconsider its profit requirement and ultimately
whether to proceed with marketing the product.

The net cashflows from these model points, scaled up for the expected new
business can be incorporated into a model of the whole company. It may be
possible that the required level of profit can be reached in aggregate without
each individual model point being profitable in its own right. However if this
is the case the company may be exposed to the risk of a change in the mix of
business.

The actuary will also consider the amount and timing of cashflows to assess
the impact on capital of writing the contract. This may lead to a redesign of
the product to reduce the capital requirements.

Once acceptable premiums have been determined for the model points,
premiums for all variations can be determined.

(iii) A stochastic method allows a probability distribution to be assigned to one or
more of the unknown future parameters.

A positive liability can be calculated where a deterministic approach might
otherwise produce a zero liability.

Future parameters can be assumed to vary together as a dynamic set, in this
case a general worsening of mortality could imply higher take up rates.

There are no embedded derivatives to consider in this contract. Stochastic
projections might be useful to determine the full range of possible mortality
rates that might occur at the date of conversion, but it is unlikely these would
give greatly differing results than scenario testing.

So the options on this contract can be valued using deterministic assumptions
for the expected take up rate and the increased mortality assumptions due to
the anti-selection effect.

Subject ST2 (Life Insurance Specialist Technical) September 2007 Examiners Report

Page 10
(iv) Market/Competition:

The company would need to look at products offered by competitors.

It should consider whether competitors are offering similar options in which
case it may need to enter market anyway to maintain market share if not it
may decide to enter the market to differentiate

It should consider whether consumers are looking for and purchasing these
options.

Market research should indicate whether there is a demand for the option.

Contract Details:

It needs to clearly define option in literature (e.g. only available at fixed
point).

The option should be available for sum assured no larger than current sum
assured

Admin Process:

It may need to make underwriting stricter at outset of policy.

It needs to ensure company can administer the option and systems are changed
in order to identify the new option.

The extra costs involved in potential extra underwriting, extra training of staff
and extra marketing literature need to be taken into account.

Other:

It needs to make a decision on whether option is profit neutral or profit making

It needs to consider whether it wishes to takeon the extra risk, Will the extra
volume and profit justify this increase in risk?

It should consider the impacts on capital requirements.

If this business is reinsured, then the views of the reinsurer will be relevant.

Part i was mostly well answered with stronger candidates scoring full marks.

Part ii differentiated candidates significantly. Stronger candidates gave good
detail of the approach in particular including discussion of how the design
and price may be iterated to meet all financial and competitive requirements.
Only a few candidates gave any detail on how the option value might be
calculated.
Subject ST2 (Life Insurance Specialist Technical) September 2007 Examiners Report
Page 11
Part iii was generally not well answered. Most candidates highlighted what a
stochastic model could do but failed to demonstrate understanding of how to
apply it to the contract being asked about.

Most candidates answered part iv well giving a good range of practical and
competitive considerations.


6 (i) 1. The reserves should be sufficient to meet all liabilities arising.

2. The reserves should be calculated using a suitably prudent actuarial
approach, and should include neither too little nor too much prudence.

3. The reserves should cover liabilities for guaranteed benefits.

4. For unit-linked policies, non-unit reserves should be held.

5. The reserves should include an allowance for future bonuses consistent
with policyholders reasonable expectations.

6. The reserves should cover future expenses.

7. The valuation should take account of the nature, term and method of
valuation of the corresponding assets.

8. The use of approximations or generalisations should be allowed.

9. The method of calculation should be such as to recognise profit in an
appropriate way over the duration of each policy.

10. The method should not be subject to discontinuities from arbitrary
changes.

11. Methods and bases should be disclosed.

(ii) The approach is consistent with the principles to the following extent:

1. The reserves by definition are sufficient to meet the death benefit. They
also meet the surrender benefit.

However, they may be insufficient to meet the maturity benefit see
later re bonus.

The approach is therefore not consistent with this principle.

2. There are no assumptions required so prudence within the elements of
the basis is not relevant.

However, holding an amount equal to the death benefit could be
considered to be unnecessarily prudent.
Subject ST2 (Life Insurance Specialist Technical) September 2007 Examiners Report

Page 12
The reserve does not take into account the fact that only a relatively
small proportion of the policyholders would be expected to die. The
approach effectively assumes that all policyholders die immediately,
and that the guaranteed minimum death benefit is paid to everyone.

The high degree of prudence is particularly the case early on in the
policy whilst the value of allocated units is less than the original
premium. And also during periods when investment markets are low
and the value of units falls to below the original premium.

Further, as noted in 1, the reserve may be imprudent to the extent that
it may not cover the maturity benefit.

The approach is therefore not consistent with this principle.

3. The minimum death benefit is a guarantee, and the reserve meets this
amount.

The payment at maturity of a minimum of the value of units is also a
guarantee, and the reserve meets this amount.

The approach is therefore consistent with this principle.

4. If the unit fund is lower than the original premium then the excess is
held as a non-unit reserve. However, no non-unit reserves are held to
cover any excess of expenses over the annual fund management
charge.

The approach is therefore partially consistent with this principle.

5. The reserves do not make allowance for the maturity bonus.

Since the potential for bonus will have been communicated to
policyholders at sale and on average a bonus has been paid over the
last few years, policyholders will have formed an expectation of it.

The reserves should make an allowance for accrued entitlement to
bonus, perhaps allowing for the proportion of policyholders expected
to stay to maturity. Otherwise, the company will have to recognise a
loss at the maturity date.

The approach is therefore not consistent with this principle.

6. No allowance is made for future expenses.

The approach is therefore not consistent with this principle.

7. The valuation takes account of the value of the units, and hence the
value of the underlying assets.

Subject ST2 (Life Insurance Specialist Technical) September 2007 Examiners Report
Page 13
The approach is therefore consistent with this principle.

8. The method can be considered to be an approximation.

The approach is therefore consistent with this principle.

9. Under this method, significant profits could emerge on surrenders.
Particularly when unit values are low.

Significant losses could also arise on maturing policies due to the
bonus.

Overall, the approach could therefore be considered to be inconsistent
with this principle.

10. Provided the method remains unchanged from year to year, there will
not be discontinuities due to arbitrary changes and the approach would
be consistent with this principle.

11. The method is very straightforward and there is no basis to disclose.

The approach can therefore very easily be consistent with this
principle.

Part i of question 6 was mostly well answered with many candidates identifying the
majority of the requirements although some wasted time giving standard requirements
that were not relevant to this particular product.

A number of candidates struggled in part ii. Many were able to pick up marks from
simple observations of principles clearly adhered to. Few however were able to show
understanding of the level of prudence from different aspects of the reserving basis
and thus lost marks.

In addition some candidates suffered from using a general discussion to answering
part ii. Candidates who used the technique of systematically discussing each of the
principles from part i tended to score more heavily.


END OF EXAMINERS REPORT
Faculty of Actuaries Institute of Actuaries







EXAMINATION


10 April 2008 (pm)


Subject ST2 Life Insurance
Specialist Technical




Time allowed: Three hours

INSTRUCTIONS TO THE CANDIDATE

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

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 the
supervisor.

4. Mark allocations are shown in brackets.

5. Attempt all 6 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 this
question paper.

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


Faculty of Actuaries
ST2 A2008 Institute of Actuaries
ST2 A20082
1 Describe the features of an accumulating with profits contract that is written in the
unitised form. [10]


2 A proprietary life insurance company is considering launching a new without profits
whole life assurance contract. Regular monthly premiums will be payable from
inception for the first 20 years of the policy or until earlier death.

Describe the factors that the company would take into account in deciding whether to
launch this product. [12]


3 A life insurance company writes a regular premium whole life unit-linked savings
contract. The premiums received in the first two years are invested in capital units,
with all subsequent premiums invested in accumulation units. The capital units have
a higher annual management charge than that applied to the accumulation units.

The company uses actuarial funding so that the supervisory reserves held are less than
the bid value of units at the valuation date.

The contract offers a death benefit equal to the full bid value of units. The surrender
value is the sum of the bid value of the accumulation units and the actuarially funded
value of the capital units.

The new Finance Director has asked whether the reserves comply with the principles
that he has seen proposed by the Groupe Consultatif des Associations dActuaires des
Pays des Communauts Europennes.

(i) Explain how the supervisory reserves, as calculated by the company, could
comply with the principles referred to by the Finance Director. [9]

The insurance supervisor requires that the company maintains a solvency capital
requirement that is calculated as a proportion of the supervisory reserves plus a
percentage of the sum at risk. The sum at risk is defined as the death benefit minus
the supervisory reserve under the policy.

The Finance Director has pointed out that holding a reserve that is less than the bid
value of units will mean a lower solvency capital requirement and that this will
provide less protection to policyholders.

(ii) Discuss these further comments made by the Finance Director. [5]
[Total 14]

ST2 A20083 PLEASE TURN OVER
4 For the past fifteen years a life insurance company has sold unit-linked single
premium investment bonds. It regularly reviews the pricing of this contract by
performing profit tests. To date it has assumed in its profit testing that the surrender
rate is a level 3% per annum in each projection year.

The company has recently performed its first surrender rate experience investigation
for this product. It has used data on surrenders that occurred during the previous
calendar year. The data was split by the duration that each bond had been in force.

The results of the investigation are as follows:

Curtate duration (in years): 0 1 2 3 4 5 6 7 8+
Annualised surrender
rate: 6.8% 4.5% 4.7% 4.2% 4.4% 9.7% 3.9% 3.4% 1.9%

Discuss the next steps that the company should take in light of these results, including
further investigations that might be required and possible changes to the profit testing
surrender rate assumption.

(You are not required to discuss ways in which the actual surrender rate experience
could be managed.) [18]


5 A life insurance company writes a range of without profits immediate annuity
business, both level and index-linked.

(i) Describe how the company might invest its assets in order to match its
liabilities as closely as possible. [8]

It has been suggested that in order to maximise returns investments should be made in
commercial property and equities as these are expected to outperform fixed interest
assets in the long term.

(ii) Discuss this suggestion. [7]

The company is now considering writing with profits immediate annuities. These
annuities would have a guaranteed annual annuity payment. Annual bonuses would be
declared which, on declaration, would increase the guaranteed annuity payment.

(iii) Discuss any additional considerations for its investment strategy in terms of
matching the liabilities. [4]
[Total 19]


ST2 A20084
6 A small life insurance company writes mainly term assurance contracts targeted at
young families. Underwriting is used to assess the terms appropriate for new
business. Past experience has shown that the mortality experience for this product line
can be represented as a fixed percentage of standard mortality tables.

(i) Describe how the company is currently exposed to model, parameter and
random fluctuations risks relating to its mortality assumptions. [7]

The company is considering designing a without profits whole life assurance contract
targeted at customers aged 50 and over. The company currently has very few
customers in this age range. It is common, but not universal, in the marketplace for
these contracts to be sold without underwriting. The company has yet to decide
whether or not to underwrite this contract.

(ii) Describe the issues the company should consider regarding the mortality risk
arising from the proposed product. [10]

The company is also considering outsourcing its administration to a major company
that carries out this service for numerous other life insurance companies. The life
insurance company would pay for the development and data transfer costs. The
administration company would charge the life insurance company a fixed fee per
policy, which would be guaranteed for 10 years and then be renegotiated for each
subsequent 5 year period.

(iii) Discuss why the company may wish to outsource its administration, including
the advantages and disadvantages of the proposal. [10]
[Total 27]


END OF PAPER
Faculty of Actuaries Institute of Actuaries









Subject ST2 Life Insurance
Specialist Technical

EXAMINERS REPORT

April 2008




Introduction

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


M A Stocker
Chairman of the Board of Examiners

J une 2008


Comments

Comments for individual questions are given in the solutions that follow.














Faculty of Actuaries
Institute of Actuaries
Subject ST2 (Life Insurance Specialist Technical) April 2008 Examiners Report

Page 2
1 Comments: This was a standard bookwork question and those candidates that clearly
had good knowledge of unitised accumulating with profits contracts tended to score
well.

The contract, as a with profit contract, participates in the profits/losses of a defined
book of business.
A regular bonus is usually added annually which will be calculated in relation to
premiums paid to date plus previously declared bonus.
A terminal bonus might also be added when a policy becomes a claim (e.g. on death,
maturity or surrender).

It looks and operates very much like a unit-linked contract, but the key difference is
how the unit prices and hence benefits are determined.

There are two ways in which the unitised part could operate:

1. Annual bonus via bonus units:
The price of the unit remains constant.
Additional units are allocated to each contract.
They are usually added annually at the bonus declaration.

2. Annual bonus within unit price:
The unit price is changed to reflect the annual bonus.
This is normally done on a daily basis.

There is a minimum guaranteed increase/addition, but this minimum could be zero.
Other than any guarantee, the bonus is completely at the companys discretion,
bearing in mind policyholders reasonable expectations.

On surrender, the company may retain the right to apply an MVR.
The size of the MVR is at the discretion of the company and bearing in mind
policyholder expectations.

Death benefits could vary according to the type of policy, for example a guaranteed
sum assured, return of premiums, return of fund. It is not usual for an MVR to be
applied to death benefits.

There is flexibility in terms of premium payments, which may be single lump sum,
recurring single premiums or regular monthly or annual premiums.

Charging structures could be any combination of charges such as policy fees,
allocation rates, bid/offer spreads, risk benefit charges, annual management charges,
surrender penalties.
Or alternatively the charges could be taken implicitly through the bonus rate, with no
explicit charging structure.


Subject ST2 (Life Insurance Specialist Technical) April 2008 Examiners Report

Page 3
2 Comments: This question was generally fairly well answered. The better
candidates tended to be more descriptive e.g. explaining that the company may
consider alternative product designs or alternative uses of capital, rather than just
describing that the company would bear in mind the capital required to write the
product.

The factors that the company would take into account in deciding whether to launch
this product include:

Demand in the market

Consider whether there is sufficient demand for this product in the market.

The extent to which there is a need for this product must be assessed. If the product
fulfils a clear consumer need then it is likely to be easier to market and sell the
product
e.g. the primary purpose of the product may be to provide for funeral expenses or it
may be to meet a tax liability that may arise on death (due to inheritance tax).

The extent to which competitors already sell similar products in terms of premium
rates and product design should be taken into account, as should the level of sales
achieved by competitors.

In assessing the likely demand for the product the insurer will also take into account
the alternative investment vehicles that may be available to the consumer to meet the
same needs.

It may be that there is a demand for this product from the distribution channels of the
insurance company e.g. if the company sells through independent financial advisers
then they may have requested the insurer to consider launching such a product so that
the insurer is offering a full product suite to meet customers needs.

The company should consider the impact on sales of other product lines within the
company it may be that sales of other products will be reduce

An alternative may be that the insurer is at risk of losing other types of business if it
does not consider adding this product to its suite of products, since, for example, a
firm of independent advisors may choose not to recommend any products from an
insurer that does not offer a wide variety of product lines.

Profitability

The company needs to make sure the product is profitable.
Profitability is a function of volumes and the expected unit profit per policy.

The company will need to write sufficient volumes of business such that the
overheads of developing and launching the product, including making system changes
and designing sales and marketing literature etc, can be covered.

Subject ST2 (Life Insurance Specialist Technical) April 2008 Examiners Report

Page 4
However, the company would not want to write such high volumes of business that
created administration problems in terms of servicing, which in turn may lead to
customer complaints/bad press.

The company would carry out cashflow projections of the business, taking into
account the expected likely future levels of investment returns, expenses (allowing for
expense inflation), mortality, lapses and withdrawals and so on, to determine the
likely future profit stream that will arise in the future.

The insurer would assess the sensitivity of the shareholders profits arising to
variations in the assumptions, (e.g. if investment returns turned out to be generally
lower than anticipated, or expenses higher than expected, mix of business by policy
size).

The insurer would need to consider the level of surrender benefits, if any, to be paid
and build this into the profit testing.

The insurer would consider whether reinsurance is available, and whether it is
necessary to manage risks. This would need to take into account the cost of any
reinsurance. There may be the possibility of obtaining technical assistance from
reinsurers.

The insurer would need to assess alternative uses of the shareholders capital and
whether there is a more profitable product that could be launched or an alternative
way of utilising the capital (e.g. launching a new distribution channel, unit linked
product, or addition of options on existing products) that is likely to offer a greater
return.

Capital required

Overall launching any new without profits contract is likely to be fairly capital
intensive, due to the initial new business strain and the capital support required at
outset.

The insurer would consider the popularity of traditional without profits contracts in
comparison to launching a other savings contracts with lower capital requirements.
(e.g. unit linked savings contracts).

The insurer would take into account the level of its free assets and its ability to write
business that is capital intensive.

Regulatory and economic environment

The insurer will consider the local regulatory environment.

It is likely that the local regulations would allow such a product to be launched but
there may be requirements in respect of the minimum surrender value that must be
paid at particular duration or there may be particular tax regulations that should be
taken into account when designing the contract.

Subject ST2 (Life Insurance Specialist Technical) April 2008 Examiners Report

Page 5
In addition, the local insurance regulator may stipulate other items e.g. a cap on the
total charges that can be taken from such a product, the impact of charges on the
death/surrender payouts if death/surrender occurred after particular durations, the
stipulation of premium rates, or level of disclosure required etc.

These will all impact the charging structure that the insurer can use and the level of
attractiveness of the product to the end consumer.

The insurer will also consider more general factors, such as the economic scenario,
and whether generally now is a good time to launch such a product

Other

The insurer would also want to consider

whether the level of risks introduced are acceptable (e.g. mortality risk)
whether the administration system can cope with this product design
any additional costs involved in training/system developments,
potential lapse and re-entry issues in the future, and may want to mitigate this risk
by, for instance, building in premium or benefit reviews, or reducing the premium
payment term (policyholders are less likely to lapse close to the end of the term)


3 Comments: Part (i) of this question required candidates to relate the valuation
principles to the product described. In many cases candidates quoted the principles
including those that were not relevant to this product e.g. mentioning bonuses but
made limited attempt to relate them to the product described. Part (ii) was poorly
answered with many candidates not using the details given in the question, and using
the terms solvency requirement and supervisory reserves loosely.

(i) The amount of reserves should be such as to ensure that all liabilities arising
out of the contracts can be met by the life insurance company.

The reserve would therefore need to cover all unit and non-unit liabilities e.g.
Unit liability on maturity
Surrender benefit
Death benefit
Future expenses
Any future commission

The reserve in total should be sufficient to cover the expected death benefit,
using the unit and non-unit reserve.

The reserve should also allow for future income from annual management
charges and take credit for charges from future premiums

Will need to ensure that the higher annual management charge on capital units
is sufficient in order to purchase units in line with funding plan and meet
ongoing expenses. This will limit the extent to which actuarial funding can be
applied.
Subject ST2 (Life Insurance Specialist Technical) April 2008 Examiners Report

Page 6
The reserve held covers the surrender value of the policy. The unit reserve
held is sufficient for this purpose.

The amount of the reserves should be calculated by a suitably prudent
actuarial valuation of all future liabilities for all existing policies.

When determining the extent to which actuarial funding can be
applied, need to make a prudent allowance for future renewal
expenses, including renewal expense inflation
The assumptions for future mortality would need to be prudent and
based on the companys recent experience.

A prudent (i.e. low) unit growth rate would also be assumed when
projecting future annual management charges for comparison against
future expenses.

The method should take into account the nature, term and method of valuing
corresponding assets and, by basing on bid value of units, the reserve complies
with this.

The method of calculation of the reserves should be such as to recognise profit
appropriately and not be subject to discontinuities. This is complied with.

Approximations can be used if necessary (e.g. using model points etc) and the
method and basis should be disclosed.

(ii) The overall protection for policyholders is maintained by a combination of the
reserves and the solvency requirement. If the reserving basis is prudent then
the solvency requirement need not be as high.

The Finance Director is correct to say that if the solvency requirement is lower
then the protection to policyholders is reduced.

The reserves in this case have been calculated in line with the appropriate
principles and with prudent assumptions. The solvency capital is additional to
the reserve, and given the reserve is designed to meet all liabilities, it is adding
to the protection for policyholders.

However holding a capital requirement that is a percentage of reserves can be
seen as a very simplistic approach to providing this protection

The overall solvency capital requirement will be positive in this case, being a
positive percentage of the all reserves plus a percentage of the sum at risk,
which will also be positive.

The Finance Director is correct that holding less than bid value of units will
result in a lower solvency capital requirement in terms of a proportion of
reserves.

Subject ST2 (Life Insurance Specialist Technical) April 2008 Examiners Report

Page 7
The sum at risk will be higher as actuarial funding has been adopted and hence
the overall solvency requirement will depend on relative proportions of sum at
risk and reserves.


4 Comments: This was a relatively straightforward question, but surprisingly many
candidates failed to score well. Many candidates failed to discuss the importance of
checking the results from the analysis and checking that the data used in that analysis
was correct. Candidates also lost marks by not describing the results of the
investigation, such as the high rates of surrender at durations 0 and 5.

Validation

The company needs to check that there are no errors in the calculations and data,
particularly since this is the first time that it has been done for this product.
It needs to check that the data is complete.
In doing these validations, it should look at both the data on surrender rates and the
data on total exposure.
It should check that all of the data is in respect of this product only.
It could use a recent analysis of surplus to check if the surrender profits/losses are
consistent with the surrender experience shown

Credibility

The company should consider the amount of exposure for each of the in-force
durations.
It should then decide whether the experience investigation results are credible.
For example there might have been very few bonds sold more than 8 years ago, which
would make the 8+result unreliable.

Relevance

The surrender rate assumptions used in profit tests should reflect the future expected
experience in respect of these contracts.
The company therefore has to decide whether this historic investigation is a fair
reflection of future expected experience.

It therefore needs to consider whether any changes have been or will be made which
might reduce the relevance of historic experience, such as:

Product design and/or charging structure.
Distribution channel.
Target market.
Investment Performance

The company should consider whether any external influences might have affected
surrender rate experience during the past calendar year, such as:

Economic environment.
Subject ST2 (Life Insurance Specialist Technical) April 2008 Examiners Report

Page 8
Level of competition in investment bond marketplace.

It also needs to consider the extent to which these external influences are expected to
continue.

Trends

The company has only one years worth of experience analysed and so it is not
possible to identify trends in surrender rates that might be expected to continue in
future.
The company should therefore perform further investigations of previous years
experience, and repeat the analysis in the future. This depends on historic data being
available.
This additional analysis will also help to give credibility to any proposal.

Assumption changes

Based on the limited analysis performed, the surrender experience would suggest that
the magnitude of the profit test assumptions should be changed, since the average is
very different from the 3% per annum currently assumed.
There also appears to be some variation in experience by duration in-force, and so the
profit test approach might be changed in order to reflect this, rather than continuing to
use a level assumption throughout the whole projection period.

Comments on specific durations

Curtate duration 0:

There is a significantly higher rate in the first year
Hence the first year rate should be increased e.g. to 7%.
However, it needs to be checked that the experience data does not include policies
which cool off at very early durations and simply receive their premium back
under statutory law and so which do not constitute a normal surrender.

Curtate duration 5:

The experience suggests a significant increase in surrenders at curtate duration 5.
This might be a feature of the product design, for example surrender penalties
being removed after the fifth policy anniversary.
If this is the case and it is supported by previous years experience (if available),
then the profit test should reflect this higher surrender rate.
However if there is no apparent reason for the spike and it occurred only in the
last calendar year, then the company might choose to average it across other
durations.

Subject ST2 (Life Insurance Specialist Technical) April 2008 Examiners Report

Page 9
Curtate duration 8+:

For policies of over 8 years in-force, the surrender experience appears to be lower
than that assumed.
Given that bonds have been in-force up to fifteen years, then if there is sufficient
volume of data available it would be useful to split this figure into individual years
in order to see whether there is any marked trend by increasing duration.
Particularly since around 65% of policies might be expected to continue in-force
beyond this duration.

Other durations:

The surrender rate appears generally higher than assumed and it would therefore
be appropriate to increase the assumptions, for example to 4.5% per annum for the
second to fifth projection years.

Other considerations

The profit test assumption of 3% per annum might include a prudential margin, in
which case the proposed changes would be even greater.

If that is the case then the cost of changing the system will have to be weighed up
against the benefit of the possible increased accuracy.

The company should consider whether other assumptions should also be reviewed in
light of this investigation, such as those used in the valuation of in-force business or
in reserving calculations.

The company should look at the sensitivity of profit to changes in the surrender
assumption.

The company might wish to look at industry-wide experience for this type of contract,
if available.

The company might wish to carry out further investigations, splitting the data by other
factors (e.g. distribution channel or size of policy).


Subject ST2 (Life Insurance Specialist Technical) April 2008 Examiners Report

Page 10
5 Comments: Part (i) was generally well answered with most candidates covering the
bookwork details well. Better candidates discussed the issues surrounding the lack of
availability of assets of a suitable term.
Part (ii) was also well answered. The better candidates recognised the importance of
splitting the returns from property and equity into rental/dividend income and gains,
rather than just describing the volatile returns from these assets.
Part (iii) was poorly answered with many candidates failing to describe adequately
the additional considerations to be taken into account in the investment strategy. A
number of candidates didn't express investment strategy in anything but broad terms
(e.g. invest in riskier assets) so did not score as well as they otherwise might have.

(i) Matching assets and liabilities

The company will wish to invest in assets that match the nature, term and
currency of the liabilities.

The benefit payments can be sub-divided into the following:
Guaranteed in money terms this consists of all future annuity payments that
are fixed.
Guaranteed in terms of an index this consists of all future annuity payments
that are linked to an index.
This could also include expenses which are not strictly guaranteed, but which
are usually treated as being linked to a price index for investment matching
purposes.

Matching investments could be as follows:
Guaranteed in money terms This is likely to be fixed interest securities.

To achieve as close a match as possible, then risk-free securities (e.g.
Government Bonds) should be used in the same currency as the liabilities.

This will involve taking into account the term of the liabilities and hence the
probability of payments being made. It may be hard to find assets that exactly
match the liability outgo, particularly since the liabilities are likely to be of
long duration and terms for fixed interest are often shorter.

Immunisation could be used but this is subject to theoretical and practical
problems.

Guaranteed in terms of an index a suitable match for index-linked annuities
would be index-linked securities.

As discussed above, this would be also be relevant for expenses.

Again the term of the liabilities should be considered and similar issues arise
as for the guaranteed in money terms liabilities. In their absence, a substitute
would be assets that are expected to provide a real return. However this
could introduce some risk if the assets are not risk free.

Subject ST2 (Life Insurance Specialist Technical) April 2008 Examiners Report

Page 11
It will be necessary to consider diversification of assets, avoiding
concentration where possible.

It will be necessary to consider any regulatory restrictions (e.g. admissibility
limits) or any tax implications (e.g. balance between income and capital gains)

(ii) Investing in property and equities

In general investing in property and equities would be expected to outperform
fixed interest in the long term, but there would be a need to consider any
regulatory restrictions that prohibit or limit investment in properties or
equities.

Property returns are made up of a mixture of rental yields and growth in
market value.

The return on rental yields may be a relatively good match to index linked
benefits, and expenses, but it is unlikely to match exactly.

Growth in property is volatile and will also cause a mismatch between income
and outgo.

Property is a long term investment and in this respect it is a match for the term
of the liabilities.

The general characteristics of the commercial property market could cause
matching or investment performance issues

Illiquidity causing delays in sales of assets
Large investments which will require a large block of annuities
High transaction costs, reducing investment performance

For equity, both income and growth can be volatile and so will cause a
mismatch.

Equities are also long term in nature and so can be a match for the term of the
contract.

The company may not have suitable expertise to invest in property or equities

The extent to which the company can depart from its matching strategy will
depend on its free assets.

The risk of insolvency would need to be considered,
for example the value of the equities could drop by large amounts in one day
but the liabilities would not change because of this.

The impact on the reserves and capital requirements would also need to be
taken into account. Mismatching is likely to increase capital requirements.

Subject ST2 (Life Insurance Specialist Technical) April 2008 Examiners Report

Page 12
Overall, subject to holding adequate capital, it may be possible to invest some
of the assets in either property or equities improving diversification;
property is more likely due to the relative stable nature of the rental income,
versus the volatile nature of dividends.

An alternative way of increasing returns would be to invest in higher yielding
fixed interest bonds.

These would have higher default rates; however, some of the additional yield
could be due to the illiquidity of the bonds. Since annuities are illiquid in
nature, as they cant be surrendered, can take credit for illiquidity premium.

(iii) Matching with profit annuities

As well as there being fixed benefits and expenses as for the without profit
annuities, there are also discretionary benefits to consider.
These discretionary benefits will be in the form of bonuses payable.
The guaranteed benefits are therefore increasing at an unknown rate.The aim
will be to maximise the returns on these discretionary benefits.

Policyholders will expect a real return on their investments.Hence the assets
should be those that expect to earn a real return, for example equities or
property.

Assets that are expected to give higher returns usually show more variance
around that return.
The extent to which the company will invest in more volatile assets will
depend on the free assets.

It will also depend in the level of guarantees under the policies.
For example it could be argued that even though the bonuses are discretionary,
policyholders have expectations around the level of future bonuses. This is
especially the case for annuities, where the annuity may be a significant
proportion of the policyholders income.

Therefore the company may wish to ensure that the probability of the bonuses
falling below a certain level is within acceptable limits and smooth bonus rates
appropriately.

Subject ST2 (Life Insurance Specialist Technical) April 2008 Examiners Report

Page 13
6 Comments: This question was not particularly well answered.
In part (i) whilst random fluctuation risks were covered well, many candidates
demonstrated a poor understanding of model and parameter risks.
In part (ii) better candidates demonstrated a clear understanding of the different
mortality risks faced under the whole of life contract, and provided a more detailed
discussion on the decision on whether to underwrite or not.
Part (iii) was generally well answered, with better candidates considering a wider
range of issues surrounding outsourcing.

(i) Model and parameter

There is the risk that the fixed percentages may become out of date and not
adequately reflect the mortality of the business written.
There is a risk that the table may become out of date and unrepresentative of
the business that the company writes.
There is a risk that the mix of business changes in the future, by
Sex
Age
Smoker/Non Smoker
Class of Life
The fixed percentage will have meant some cross subsidies are likely to have
existed in the past.
The view of future mortality improvement or deterioration may have changed
and hence the level within the table may not be appropriate, or equally may
affect different classes of lives in different ways invalidating the assumption.

There may be an anti-selection risk if the market changes and other companies
target certain lives (e.g. non smokers, specific classes or age ranges)
Any changes in underwriting process will invalidate the assumption.
Changes to the target market or distribution channel would invalidate
assumptions.
There may be a potential impact arising from a tranche of selective
withdrawals.

Random Fluctuations

The company is small and so it is possible that it has a small number of claims
in any given year.
This means that is may be susceptible to random fluctuations.
Abnormally heavy claim experience may threaten the companys solvency.
This could happen through particularly large claims, or as a result of an
unusually high number of claims.
New diseases or disasters could result in high claims.

(ii) The company has little experience in the mortality of the proposed age group.

Mortality improvements (or deterioration) over time may be different for
different age groups.
The fixed percentage approach used for the existing contract may be overly
simplistic for this age group.
Subject ST2 (Life Insurance Specialist Technical) April 2008 Examiners Report

Page 14
It is possible that the customers for the new contract come from a different
socio-economic group to the existing contract type.The possibility of no
underwriting would also make the new population significantly different to the
existing population.
The current model may therefore be inappropriate andthe current parameters
are likely to be inappropriate.
By moving into a new market and, therefore, possibly leading to a significant
increase in the number of customers, the random fluctuation risk could be
reduced.
In order to derive a suitable basis for this product the company should
Consider the information available from the published mortality
investigations (from actuarial profession or other sources).
Seek the advice of its reinsurers, as it is very likely that it will reinsure
some of the new business.
The decision whether to underwrite or not is very important.
No underwriting would
Possibly be more in line with the market for this product
Be cheaper, due to no underwriting costs
Not increase the number of claims (as whole of life)
But would accelerate them
Specifically, there may be some claims close to the point of sale.
The different claim profile is not a problem as long as it is reflected in the
pricing basis.
Having underwriting would
mean that your product was cheaper due to select mortality
But customers may be prepared to pay higher premiums in order to avoid
underwriting.
The cost of underwriting may be prohibitive if average sum assured is low.

If not all policyholders are underwritten then the company could be exposed to
anti-selection risk.
To make the decision would need market research.
Sales volumes may be higher if there is no underwriting
A market niche with sufficiently high sums assured could justify
underwriting?

(iii) Competitiveness in the market may mean that expense control is an important
issue for the company.
The company will want to increase profitability, and outsourcing may enable
this. As the company is small it may be that it cannot achieve the same
economies of scale as its competitors.
Outsourcing may increase the new business capacity of the company.
It is possible that developments required, for example, regulatory changes are
costing a disproportionate amount of the companys expense budget.
The company may be finding it difficult to recruit and retain staff.
It may be concerned that it has not and will not be able to maintain cost
control and so costs may rise faster than its competitors.

Subject ST2 (Life Insurance Specialist Technical) April 2008 Examiners Report

Page 15
Advantages

The outsourcing company may have better customer service standards than
those currently within the life company, leading to potential better retention of
policies.
Entering into the arrangement will give greater certainty to the costs that the
company will incur over the guaranteed period.This will enable greater
confidence in pricing and reserving.
The fee may result in lower fixed expenses.
The outsourcer may have better IT systems than the company and thus
improve servicing overheads.By putting the business on the same IT platform
as the outsourcers other clients, the company is achieving a greater economy
of scale.The costs of future industry wide changes can be shared with the other
companies.The development costs of new products may be reduced as the
outsourcer may have experience of the new product types.
If underwriting process is outsourced then the life company may benefit from
better underwriting service standards and reduced underwriting costs.
This may free management resource for other areas of the business.

Disadvantages

The company is no longer directly in control of customer contact. As a result,
the company will wish to agree the service standards that the outsourcer
should apply to ensure that the company does not suffer from customer
dissatisfaction and consequential brand damage.
If underwriting processes are outsourced then the life company will suffer
from a loss of control over those processes and may experience a fall in
underwriting standards.
The company is liable for the migration and development costs and risks
inaccuracies and work not being completed on time.These costs will be crucial
in the business case justifying the decision.
The life company will have limited control over these costs, as a significant
proportion will be incurred by the outsourcer.
There will be an increased policy size risk due to having a fixed fee per policy.
There may be limited control over the fees that will be charged at each
renegotiation.If the rise is significant the company may have to move the
business back in-house or to another outsourcer.The likelihood of this will
depend on the existence of other outsource companies and the ease of
migration.
Being a comparatively small company the level of influence the life company
will have over the outsourcer will be limited, especially when it comes to
renegotiation of fees or service standards.
Term assurance and whole of life are relatively straightforward contracts to
administer and so it may be possible to move them quite easily.
However, it would be better to agree some principles regarding the possible
increase in fees in order to reduce the need to move the book again.
There may be brand damage resulting from possible redundancies, as well as
the costs associated with such redundancies.
The company will need existing staff to make a success of the migration.
Maintaining morale through the period of uncertainty will be a challenge.
Subject ST2 (Life Insurance Specialist Technical) April 2008 Examiners Report

Page 16
There is a potential for a loss of expertise and with it a loss of product
knowledge.
Whilst a substantial section of the companys expense base will have been
outsourced, there will be some elements remaining and so there will be some
variability left.
The company would need to consider the risk of administration company
defaulting.


END OF EXAMINERS REPORT

Faculty of Actuaries Institute of Actuaries







EXAMINATION


18 September 2008 (pm)


Subject ST2 Life Insurance
Specialist Technical




Time allowed: Three hours

INSTRUCTIONS TO THE CANDIDATE

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

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 the
supervisor.

4. Mark allocations are shown in brackets.

5. Attempt all 7 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 this
question paper.

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


Faculty of Actuaries
ST2 S2008 Institute of Actuaries
ST2 S20082
1 Describe what is meant by a non-unit reserve in the context of unit-linked life
insurance contracts. [3]


2 A life insurance company has a portfolio of conventional without profit endowment
assurances.

(i) Give the formula used for calculating the surrender value on a prospective
reserve basis, defining all terms used. [4]

(ii) Outline the principles that should be taken into account when determining the
surrender value. [4]

As an alternative to surrendering the policy, there is an option for the policyholder to
make the policy paid up for a reduced sum assured.

(iii) Describe the additional considerations that should be taken into account when
calculating the paid up sum assured. [3]
[Total 11]


3 (i) State the main reasons a company would perform an analysis of Embedded
Value profit. [2]

A life insurance company has just performed an analysis of Embedded Value profit
and identified that the withdrawal experience on its term assurance business was
higher than its assumptions.

(ii) Discuss the likely impact of the higher withdrawals on its embedded value. [5]

(iii) Suggest possible causes of the higher withdrawals. [3]

The company wishes to understand the cause of these higher withdrawals and has
decided to perform an analysis of its withdrawal experience.

(iv) Describe how it might choose to subdivide its data in order to get a better
understanding of the causes. [5]
[Total 15]

ST2 S20083 PLEASE TURN OVER
4 A proprietary life insurance company sells monthly premium conventional with
profits endowment assurance policies.

Consider one such policy that was in-force at both the start and the end of a calendar
year, and for which the asset share was known at the start of the calendar year. An
inexperienced actuarial student has been asked to write a formula for the calculation
of the asset share of that policy at the end of the calendar year.

He has proposed the following formula:

Asset share at end of calendar year =
Asset share at start of calendar year (1 +Investment return)
+Total annual premium
Per policy renewal expense loading
Commission
Cost of guaranteed death benefit
+Annual bonus
+Transfer of profit to shareholder

Where:

Investment return is the total domestic equity market return over that calendar
year, derived from indices.

Per policy renewal expense loading is obtained from a detailed expense
allocation model that splits direct salary, property and computer costs between
products and between initial, renewal and termination expenses.

Cost of guaranteed death benefit is defined as the guaranteed minimum sum
assured multiplied by q
x
(where x is the age of the policyholder at the start of the
year).

The company uses an addition to benefits approach to profit distribution.

Describe the improvements that could be made to this proposed formula. [12]


ST2 S20084
5 A life insurance company is considering writing a new flexible unit-linked product
that would be targeted at high net worth individuals. The product would allow
flexibility in terms of premiums payable and could be used either as a savings vehicle
or to provide life cover, or a mixture of the two. The life cover would be charged via
deductions from units. These charges would be based on mortality rates guaranteed at
the point of sale.

The only other charge would be an annual management charge of 1% p.a., and this
would be guaranteed not to change. The surrender value would be the bid value of
the units.

The contract would allow cover to be increased or decreased within limits without any
medical evidence at the time of certain lifestyle changes (e.g. marriage, birth of a
child); otherwise the usual underwriting procedures would be used.

Commission would be paid by the customer directly to the insurance intermediary.
Any medical fees incurred as a result of medical tests required during the
underwriting process would also be paid directly by the customer.

(i) Discuss the factors to take into account when considering the profitability and
marketability of the product. [10]

The marketing manager has suggested that since the product is aimed at high net
worth individuals, any policyholders who have been accepted at standard rates should
be able to increase the level of life cover within the previous limits at any time
without the need for further underwriting. He says that the decrease in expenses
should outweigh the cost of any downside in experience rates, and that sales should
increase. He also suggests that any impact on experience could be managed by
making the charges applied for life cover reviewable.

(ii) Discuss these suggestions. [9]
[Total 19]


6 (i) Outline the key requirements of an actuarial model. [5]

A life insurance company uses a deterministic model in the profit testing of its
immediate annuity business.

(ii) Describe why it might wish to use sensitivity analysis as part of this exercise.
[4]

(iii) Discuss the assumptions on which sensitivity analysis is likely to be
performed. [5]
[Total 14]

ST2 S20085
7 A well established proprietary life insurance company has decided to start selling a
new type of regular premium with profits endowment assurance contract.

The product is aimed at the parents of young children. It has a term to maturity of 20
years and is taken out on a single life basis. Each year regular bonuses are added to
the initial sum assured. Payments of benefits are at the durations set out in the table
below.

Duration 14 years 16 years 18 years 20 years
Benefit
Payable
25% of Initial
Sum Assured
25% of Initial
Sum Assured
25% of Initial
Sum Assured
25% of Initial
Sum Assured
plus Regular
and Terminal
Bonus

If the parent taking out the policy dies at any time during the policy term, a death
benefit equal to the initial sum assured is payable and all future premiums are waived.
The benefits at duration 14, 16, 18 and 20 are also still payable.

In the event of the death of the child no further premiums or benefits are payable and
the policy ceases.

No surrender benefit is payable during the first two years of the contract, although a
surrender benefit is payable thereafter.

(i) Discuss the advantages and disadvantages of this product for a young couple
who have just had their first child. [10]

(ii) Discuss the risks that the insurance company should consider when launching
this contract. [16]
[Total 26]


END OF PAPER
Faculty of Actuaries Institute of Actuaries








Subject ST2 Life Insurance
Specialist Technical

EXAMINERS REPORT

September 2008






Introduction

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


R D Muckart
Chairman of the Board of Examiners

December 2008


Comments

These are given at the beginning of each question.












Faculty of Actuaries
Institute of Actuaries
Subject ST2 (Life Insurance Specialist Technical) September 2008 Examiners Report

Page 2
1 This question was well answered by most students, Whilst most candidates identified
the main points, few candidates knew all of the book work.

A company will have non-unit liabilities under its unitised contracts, e.g. expenses, or
benefits in excess of the unit value, for which it receives monetary payments in the
form of future charges it extracts from the policies.

If it expects that charges will not be sufficient to meet these liabilities at any point on
a cashflow basis, it has to hold a non-unit reserve to provide for the deficiency.

It may be possible for a company to hold a negative non-unit reserve, where it expects
the future charges will be more than sufficient to meet the future non-unit liabilities.


2 Generally parts (i) and (ii) were answered well, with part (iii) being less well
answered. In part (i), the most common mistakes were candidates not using the
information provided in the question and candidates failing to define all of the items
in the formula.

(i)
( ) ( )
:
: :
( )
m m
x t n t
x t n t x t n t
S f A ea Ga C
+
+ +
+ +

Where:

S is the sum assured
f is the normal claims expenses
x is the age of the policyholder at date of issue
t is the duration of the policy since inception
n is the term of the endowment
m is the frequency of the premium
G is annualised premium
C is the cost of the surrender
e is the annual expense from administering the policy

(ii) The surrender value should take into account:

policyholders reasonable expectations
fairness to both the exiting customers and those customers remaining
not exceed asset shares, in aggregate, over a reasonable period of time
should not appear too low at early durations compared to premiums paid
and projections given at the new business stage
competitors offerings
be consistent with maturity values at later durations
be consistent with what the sum assured would be if the outstanding term
was reduced to zero
not be subject to frequent change, unless economic conditions dictate
not being excessively complicated to calculate
be capable of being documented
Subject ST2 (Life Insurance Specialist Technical) September 2008 Examiners Report
Page 3
profit on surrender should be consistent to as if the policy had not been
exiting
the lapse and re-entry risk of setting too high a surrender value
the need for compliance with any regulations or professional guidance

(iii) Additional considerations for paid up sum assured:

there is a need to consider expenses not just for making the alteration to
the contract, but also the ongoing maintenance expenses
the effect of mortality selection likely to be less than for surrendered
policy because policy remains in force
the paid up sum assured should be consistent with surrender values
the surrender value should be the same before and after conversion
the paid up sum assured should be supported by the earned asset share, at
the date of conversion, on the basis of expected future experience
the paid up sum assured should, at later durations, be consistent with
projected maturity values allowing for premiums not received
the paid up sum assured should be consistent with an alteration where the
premium is reduced close to zero
the profit taken at being made paid up should be consistent to as if policy
had stayed premium paying


3 Part (i) was well answered and is standard book work; the most common error made
by candidates was to answer why a company would perform an analysis of surplus.
Part (ii) was poorly answered. The most common mistake made was to refer to a
retrospective asset share on a term assurance product, rather than considering a
prospective comparison of premiums, claims, expenses and reserves. Parts (iii) and
(iv) were typically well answered.

(i) A company will analyse the change in its embedded value in order to:

validate the calculations, assumptions and data used
reconcile values for successive years
provide management information
provide detail to publish in its company accounts, for example, the value
of new business written
provide information as part of a prospectus for sale of the company

(ii) The withdrawal itself will have no cost associated with it.

The company will lose the value of future premiums, this will be offset by the
expected value of claims that will no longer occur and any reduction in the
expenses of managing the policy and paying the claim. There may also be a
release of reserves.

The impact on the embedded value will depend on whether the value of future
premiums is greater than the expected value of the claims and expenses and
the reserve release.
Subject ST2 (Life Insurance Specialist Technical) September 2008 Examiners Report

Page 4
Early on in the term of a policy you would expect the value of future
premiums to exceed the value of future claims, expenses and reserve.

So the embedded value will tend to reduce on lapse.

Over time the cost of claims increase as policyholders age whereas premiums
are normally level. There is also likely to be an increase in reserve held.

It is possible that close to the end of the term of the policy the expected value
of claims, expenses and reserve release exceeds the value of future premiums.

So the embedded value may increase on lapse.

The impact may also be distorted by reinsurance, if the timing of reinsurance
premiums and claims are not in the same proportion as the overall premiums
and claims.

In addition, there may be distortions from an uneven incidence of premiums,
for example, escalating premiums or premiums stopping before the end of the
term of the contract.

If the experience leads to a change in the assumption for future withdrawals,
then there will be an additional impact on the embedded value.

In addition, higher withdrawals may lead to higher per policy costs, which in
turn reduces the embedded value.

Higher withdrawals may be selective, which may affect the mortality
assumption.

(iii) It is possible that other companies have advertised lower premium rates such
that customers can get the same benefits cheaper.

The company may have even reduced its own rates leading to lapse and re-
entry.

Advisors may actively review market rates and highlight opportunities for
customers and encourage them to withdraw and take out other cover.

Alternatively, mis-selling by advisers or the company may have led to
inappropriate sales and higher subsequent lapse experience.

There may be an economic downturn, leading to customers having less money
to pay premiums.

The company may have recently suffered bad publicity.

This may be driven by the poor customer service.

Subject ST2 (Life Insurance Specialist Technical) September 2008 Examiners Report
Page 5
In particular bad publicity about its claims handling may reduce the
confidence of the customer in the company.

The higher level of withdrawals may be as a result of random fluctuations.

The original assumption may have been unrealistic.

(iv) The company is likely to subdivide data by duration from entry as experience
may differ by the time a policy has been in force. For example, there may be a
higher incidence of lapses early on in the term.

The company is also likely to split its data by source of business, different
distribution channels may have different experience. For example, business
from advisors may be worse than through direct sales channels as advisors
may more actively search for improved terms for their clients.

In addition experience from different individual distributors may be different
and the company may wish to look into this.

The socio-economic grouping of customers may also be explored as customers
in different groups may exhibit different behaviours. Premium size or
geographical location may be used as a proxy here.

In addition the company may split data by the age or sex of the policyholder.

The company may also want to isolate customers who had been accepted on
loaded premiums. These may exhibit worse experience if medical conditions
causing their loadings had cleared up such that they could now get cheaper
cover.

If different policy types with different options are in force, data may also be
split into the distinct variants.

Different premium payment methods may also be analysed as well as
premium frequencies, for example separating out single premium policies.

The company may split the data by type of term assurance (eg level term,
decreasing term) to determine whether the higher withdrawals relate to a
particular product type.

The company may also split the data by original term, splitting the analysis
into short term and longer term policies.

The company may also take into account specific events that might affect
withdrawal experience, for example, changes to the way the policy is taxed.

The number of divisions used will depend in part on the volume of data
available. The company will be keen to ensure each data cell used is credible
such that results are meaningful.

Subject ST2 (Life Insurance Specialist Technical) September 2008 Examiners Report

Page 6
4 This question was not very well answered. The better candidates were able to suggest
improvements to those items mentioned in the question. Where candidates struggled
was in identifying missing elements of the asset share.

Investment return

It is acceptable to base the return on indices, but it would be preferable to use the
actual return achieved on the underlying assets.
The return should be based on all of the types of asset in which the with profits
fund is invested, not just equities.
The assets are also likely to include overseas equities, property and fixed interest
investments.
The precise allocation of assets appropriate to this policy might take into account
its duration in force and/or accrued level of guarantees.
The investment return may need to be netted down to reflect tax.
Other items in the formula need to be increased by investment return.
For example, premiums and expenses could be assumed to occur halfway through
the year and therefore should be increased by half a years investment return.
Alternatively, premiums and expenses can be allowed for monthly including the
appropriate increase for investment return.
Smoothed investment return may be allowed for since some companies may use
this approach.

Premium

It would need to be checked that this policy does not become paid-up during the
year.

Expenses

It is not clear that allowance has been made for investment expenses, this should
be explicit.
The same is true for overheads.
Allocating expenses completely on a per policy basis might not be appropriate.
The expenses and commission may both need to be netted down for tax.
Need to ensure that the expense loading allows for an appropriate period of
inflation.

Death Benefit

The treatment of the cost of the death benefit is inaccurate. It should not be based
on the whole guaranteed minimum sum assured, but the excess of the actual death
benefit over the asset share, where the actual death benefit allows for bonuses.
It should also be divided by (1 - q
x
) to reflect the fact that the cost can only be
shared across those policyholders that survive the year.
The table from which q
x
is to be taken should be defined.
Alternatively the cost could be based on the actual mortality experience during the
year.
Subject ST2 (Life Insurance Specialist Technical) September 2008 Examiners Report
Page 7
Annual bonus

This should not be included in the calculation as it has no impact on the asset
share, which reflects the build-up of actual assets underlying the policy rather than
the build-up of the benefits that are communicated to the policyholder.

Shareholder transfer

This should be a deduction from the asset share, not an addition.

Other items

The formula could also include:

the cost of providing any guarantees or options
the cost of any capital necessary to support contracts in the early years
a contribution to the free assets, which support the smoothing of bonuses and
investment freedom
an allocation of profits on without profits business, if appropriate
an allocation of profits on surrenders of other with profits contracts


5 In general, this question was poorly answered and proved to be the most challenging
in the paper. Part (i) was marginally better answered than part (ii). Candidates were
comparatively better at identifying items on marketability than profitability in part (i)
For part (ii), most candidates were able to identify the increased anti-selection risk,
the increased marketability of not having any underwriting and that reviewable rates
would make the product less marketable. Few candidates were able to identify the
mitigating actions the company would take if no underwriting was performed and the
effect of selling more business.

(i) Profitability

The charges need to be sufficient to cover both the expenses and profit margin.

The sensitivity of profit also needs to be considered.

In particular, due to the back-end loaded nature of the charging structure,
profits from this contract are likely to accrue later in the policy term giving
more risk it will materialize.

If investment performance is poor, the 1% annual management charge may not
be sufficient to meet the fixed expenses.

The commission and medical fees are paid for directly and so the profits will
be less sensitive to the number of times a customer increases their protection
element. However, there are other initial expenses and underwriting costs
which need to be covered by the annual management charge and these should
be considered.
Subject ST2 (Life Insurance Specialist Technical) September 2008 Examiners Report

Page 8
In particular, the annual charges may be low if the customer does not use this
as a savings contract as the funds will be low or ultimately zero. The company
should therefore consider allowing for some expense loadings in the protection
charges, but this would affect the marketability and competitiveness of the
contract.

The sensitivity of the profit to the level of the savings element should be
tested.

If up-front costs are high, the profit will be sensitive to higher than expected
levels of surrenders at early durations.

The profitability needs to allow for the cost of any reinsurance used by the
company.

The level of profitability will depend upon the volumes of business sold.

The profit will be sensitive to the size of the premium if some costs are fixed
in nature. The company may want to set a minimum premium to ensure that
the value of the management charge is sufficient to cover fixed costs.

The option to increase or take out new protection on a lifestyle change could
make the company open to anti-selection, but this is not likely to be an issue if
the conditions are strict enough.

The flexibility of the contract could result in more administration costs, which
might affect profitability.

Guaranteeing the rates from the effective date does introduce an element of
risk which could affect profitability. However, this is no different to rates
being guaranteed on level premium business and this may be a risk the
company is willing to take.

Marketability

The marketability of the will depend on what the companys competitors are
offering.

The contract is very flexible and so should appeal to customers.

The guaranteed annual management charge and the guaranteed mortality
charges are also appealing.

The transparency of the charges is likely to appeal to customers as they can
see exactly what they are paying for.

In addition, further protection contracts can be taken out without the need for
paying for the initial overheads you would usually have to pay for.

Subject ST2 (Life Insurance Specialist Technical) September 2008 Examiners Report
Page 9
However, medical fees and commission payments are expensive and having to
pay these directly may make the contract less marketable, even though these
charges would be loaded into the contract in some other way, if these were not
paid for directly.

This is exaggerated by the fact that high net worth customers will tend to need
higher levels of protection, which in turn usually requires more medical tests,
which could make the contract less marketable. In addition, if the company is
not paying, they may ask for more tests than they would do otherwise.

Since commission is paid directly this may limit the distribution channels open
to the company, hence this could reduce marketability.

A restricted choice of funds may not be marketable to high net worth
individuals.

Limits on when underwriting free increments may be made on the policy may
be too restrictive.

No penalty on surrendering the policy would be a marketable feature.

The level of marketability of the policy will be affected by the size of the high
net worth target market.

(ii) Disadvantages of the suggestion

No underwriting:

The suggestion could introduce anti-selection risk where applicants in ill
health would be able to take out increased life cover. Also, applicants who
currently have a clean medical record, but suspect for some reason they may
become ill may take out the contract.

Underwriting requirements at the point of sale may need to be stricter, because
consideration would have to be taken of the potential sum at risk from future
increases as well as for the level applied for on application.

This could both increase costs for the life insurance company and for the
applicant making it less attractive for those who only want a small level of
cover. This could reduce sales.

The company needs to consider whether the level of risk taken on by this
suggestion is acceptable.

The level of reserves would need to increase if no underwriting is performed,
since the mortality experience would be expected to worsen.

If the product is reinsured, the company would need to check with the
reinsurer before making any changes.

Subject ST2 (Life Insurance Specialist Technical) September 2008 Examiners Report

Page 10
Reviewable rates:

Reviewable rates might make the contract less marketable.

It may also increase systems or administration complexity.

Advantages

No underwriting:

The ongoing expenses would reduce because even though medical fees are
met directly, there are other underwriting expenses which may not be covered
by the annual management charge.

The marketing manager may be correct and the savings could outweigh the
cost of the additional risk.

The contract may be more marketable.

Volumes could increase, which would also reduce per policy expenses, the
level of further increases in cover would also increase. However, the increase
in volume is likely to be mainly due to anti-selection.

A worsening in mortality experience could be mitigated by an increase in
standard rate charges offered to new business, but this could mean that the
healthy lives go elsewhere leaving the company with even worse experience.

Reviewable rates:

Making the rates reviewable would certainly ease the situation as it would
allow any worsening of experience to be charged for.

In addition, the rates quoted could be lower as they do not need to incorporate
the same risk margin for potential adverse deviations, which are required for
guaranteed rates.

Reviewable rates may lead to lower reserving requirements.

However, there is a limit to how much rates can be increased by as
policyholders will have certain expectations.

The level of impact on introducing reviewable mortality rates and no
underwriting will also depend upon the practice and reaction of the companys
competitors

Overall, it is unlikely that the risks involved would be acceptable.


Subject ST2 (Life Insurance Specialist Technical) September 2008 Examiners Report
Page 11
6 Part (i) was well answered. Part (ii) was poorly answered, with insufficient detail
being included and few candidates venturing beyond general comments about profit
sensitivity and assessing margins. In part (iii), most candidates considered mortality,
however a common mistake was to forget that assumed investment returns are locked
in at outset.

(i) A model must be valid for the purposes it is being put, it must be rigorous and
adequately documented.

Model points must adequately reflect the distribution of the business being
modelled.

Parameters used must allow for all those features of the business being
modelled that could significantly affect any advice given as a result.

Parameter values should be appropriate to the business being modelled and
should take into account the special features of the company and the business
environment it is operating in.

The model should allow for any internal consistency of parameters, for
example, inflation and asset investment returns.

Outputs should be capable of independent verification for reasonableness and
should be communicable to whom advice is given.

The model must not be overly complex, such that results become difficult to
interpret or the model becomes too long or expensive to run.

(ii) Sensitivity analysis may be carried out at an individual policy level and at a
portfolio level.

At an individual policy level, sensitivity analysis allows the company to
understand the impact of misestimating parameter values in the model.

It can help show what the reductions would be in profits emerging, return on
capital or other metrics targeted.

This may help assess what margins may be included in the parameter values
for the risk that are not borne out in reality.

At a portfolio level, sensitivity analysis can be used to assess the impact of
shifts in mix of business.

Some parts of the portfolio may be more profitable than others and this
analysis will highlight the possible impact on overall profitability of the
product.

Sensitivity analysis on the volume of business can also be used to assess the
overall profits emerging. This may be useful to validate the viability of any
Subject ST2 (Life Insurance Specialist Technical) September 2008 Examiners Report

Page 12
development expenditure associated that may be associated with the pricing
exercise.

This can also help the company to understand the possible risk to its capital
position if volumes are more than expected.

(iii) The company is likely to perform sensitivity analysis on its mortality
assumptions. The future outgo in respect of the policy is determined by this
assumption and variations in it may significantly impact on the profitability of
contracts.

This analysis may be split into different aspects including current base
mortality experience and improvements in mortality over time.
The company may also consider sensitivities in expenses. Administrative
expenses may be relatively low but expense inflation may be important given
polices may be in force for a number of years.

Mix of business may also be a factor that needs exploration. Mix across ages
and sex may be important if commercial reasons lead to pricing at different
levels of profitability across the portfolio.

The sensitivity of profit to new business volumes may also be tested, as might
changes in average case size, since both may impact on the companys ability
to cover expenses.

The company is unlikely to look at investment returns over time as
investments are locked in once the policy is sold, unless the company has
made a strategic decision to invest in non-bond assets to back the liabilities. A
more relevant factor to investigate would be changes in the yield on the
investment used to match the annuity payment if mismatching is employed.

Profits on such contracts may be particularly sensitive to small changes in
yields, if these are not automatically reflected in changes in annuity terms
given.

In addition the company may wish to look at the potential impact of increases
in defaults in its Corporate Bonds, particularly if companies with lower credit
ratings are used.


Subject ST2 (Life Insurance Specialist Technical) September 2008 Examiners Report
Page 13
7 The question was reasonably well answered with part (i) proving less challenging
than part (ii). In part (ii), whilst expense risk was well covered, investment risk was
not very well covered and few candidates considered the potential mitigating action of
reducing bonuses. Capital risk was only covered by a few candidates.

(i) The advantages of this product for a young couple who have just had their first
child are:

The product provides both a benefit on the death of a parent and benefits when
the child is a teenager and hence offers a good mix of savings and protection
benefits.

The product provides staggered lump sum benefits, which can be used to pay
for education fees at key ages during a childs secondary and tertiary
education. The parents will be able to use the lump sums to meet expenses
such as private school/college and university fees, board/lodging fees at
university, school trips, and private tuition.

They could equally use it for other things, to improve the familys financial
security, such as paying off a home loan.

The final benefit payable at duration 20, which includes all of the accumulated
bonuses and final bonus, is likely to be a fairly large sum (compared to the
payouts at duration 14, 16 and 18) and could be used, for example, to pay off
any debts that the child has accrued whilst at university, or to provide a
deposit for the childs first property (either buying or renting).

The product also provides life insurance cover in the event that the parent
taking out the policy dies during the policy term, which will be useful in
providing some financial security for the child in the event of the early death
of the parent.

The fact that future premiums are waived in the event of the parents death is
an added advantage since it means that the policy will still provide the lump
sum series of payments during the childs secondary and tertiary education,
even if a death benefit has already been paid out.

It is possible that there will be some tax advantages to the parent taking out
this policy, either the premiums payable throughout the policy term may be
deductible from taxable income, i.e. income tax relief will be received on the
premiums, or the final maturity/death benefit may be paid free of income tax.

The product is regular premium and with profits, meaning that the parent
taking out the policy starts saving regularly, the product introduces a savings
habit, which may not currently be there. Also the parent benefits from
receiving smoothed investment returns during the term of the policy.

Whilst we are not told the investment strategy of the with profits fund it is
likely that the with profits fund will be invested, to some degree, in equities
and hence will provide a positive real rate of investment return over the long
Subject ST2 (Life Insurance Specialist Technical) September 2008 Examiners Report

Page 14
term in excess of that which could be earned by investing in less aggressive
investments, for example, in a bank/building society deposit account.

A policy written on a single life basis will be cheaper than one written on a
joint life first death basis.

The disadvantages of this product are as follows:

Since the product combines both protection and savings elements it is likely to
be relatively expensive, certainly much more expensive than if the parent just
took out term assurance.

We are told that the couple are young and have just had their first child, hence
they are unlikely to have a high level of disposable income to spend on a
savings policy and a term assurance may be more suited to their budget.

The product is only to be taken out by one of the parents and hence only
provides life insurance cover for the parent taking out the policy. In addition
the future benefits are no longer received if the child were to die

Even though they have had a child, it is likely that the couple need life
insurance to cover both parents; either both parents will work, or in the event
that one of the parents stays at home to care for the child, in the event of their
death, life insurance cover would be useful to provide money to pay for
childcare.

The product invests in a with profits fund. The couple may not like the lack of
transparency associated with investing in a with profits fund and they may
prefer to invest in, say, a unit-linked contract, instead.

Similarly, a with profits savings policy from an insurance company may be
seen as an expensive option, due to the high charges that the insurance
company may take, and the couple may prefer to take, for example, a joint life
term assurance policy, and invest regularly in a different savings vehicle such
as unit funds/mutual funds.

The pattern of benefits offered may not match the needs of the parents, for
example, they may need a regular payout each year between ages 11 and 16
for the product to meet regular school fees. The product could be made more
attractive if the parent had some choice at outset regarding the pattern of
benefit payouts.

Inflation may erode the value of the fixed interim payments to the
policyholder.

No surrender in the first two years will mean that the policyholder will not be
able to recover any value from the premiums paid in, if their financial
circumstances change.

Subject ST2 (Life Insurance Specialist Technical) September 2008 Examiners Report
Page 15
Due to the likely high premiums, the couple may find it difficult to maintain
paying the premiums if their joint income falls substantially, for example, if
one of them falls sick or has a serious accident. The product might be more
attractive if it were to offer rider benefits to cover such eventualities.

(ii) The risks that the insurance company must consider in launching this contract
include:

Investment risk

This is a savings contract and hence the main risk is that the product fails to
meet the levels of investment return expected by the policyholder.

Investors will expect a reasonable level of real return, in the form of regular
and terminal bonuses, throughout the term of the policy. They may compare
the regular bonuses received during the policy term to investment returns on
bank deposits or on savings in unit trusts/mutual funds.

The company must invest in assets that will maximise the returns to the
policyholders for an acceptable level of investment risk in accordance with the
way the insurance companys with profits fund is marketed and was described
to the policyholder at inception.

The insurer will have to take into account any local regulations, which may
govern the asset classes that the insurer may invest the with profits fund in.

In addition the profile of guarantees and payouts may influence the investment
strategy and constrain investment freedom.

There is a risk that the returns on the with profits fund are poor in relation to
other insurers with profit funds and hence, for example, the insurer may
struggle to sell this business in sufficient volumes if the insurer has a
reputation of providing poor with profits payouts (e.g. measured by surveys in
the financial press).

Investment risk can be passed back to policyholders via reduced bonuses,
however this will also impact the level of shareholder profits and the future
marketability of the product.

The company runs the risk of the return being insufficient to meet the
guaranteed benefits on the policy.

Mortality risk

Whilst the product is a mixture of savings and protection, death benefits are
provided and hence there is a mortality risk to the insurer.

In particular, the death strain on early deaths will be higher than a regular
endowment product due to the double benefit provided under the contract of
Subject ST2 (Life Insurance Specialist Technical) September 2008 Examiners Report

Page 16
both payout of the sum assured and the provision of the maturity proceeds,
with waiver of premium.

The insurer is exposed to the risk of deaths early in the policy term, when the
death benefit will far exceed the policys asset share.

The insurer will usually try to minimise this risk through appropriate
underwriting.

The insurer will deduct mortality charges from the asset share of each policy
to pay for the mortality risk that the policy represents.

If the insurer reinsures the mortality risk, it will be exposed to the risk of the
reinsurer defaulting.

Apart from early deaths, the risks to the insurer are:

(a) at a portfolio level, that there are generally more deaths than expected
such that the mortality charges taken in aggregate are insufficient to
meet the death benefits paid out in excess of asset shares.

(b) that policyholders generally die earlier than expected, meaning that,
under the waiver of premium benefit, the premiums are paid by the
insurance company for a longer period than expected i.e. the company
has underestimated the cost of providing the waiver of premium
benefit.

If child mortality has been allowed for, the company is at risk from fewer child
deaths than allowed for in the pricing assumptions.

Mortality can be passed back to policyholders via reduced bonuses, however
this will also impact the level of shareholder profits and the future
marketability of the product.

Lapses and surrenders risk

We are told that no surrender value is payable during the first two years of the
policy term. During the first two years, the asset share is likely to be negative,
due to the high initial expenses of setting up the policy and paying
commission etc.

Hence, even though no surrender value is to be paid out during this period,
there is still a risk of higher than anticipated early surrenders/lapses, since the
asset share is negative during this period and the company will make higher
losses than expected if early surrender rates are higher than anticipated.

Profits are likely to arise for shareholders as a proportion of the regular bonus
declaration each year. Hence more surrenders than expected will lead to a
lower volume of in-force business and a lower stream of profits for the
shareholder.
Subject ST2 (Life Insurance Specialist Technical) September 2008 Examiners Report
Page 17
Some lapse risk may be passed on to the customer through lower bonuses.

At later durations, the level of risk depends upon the relationship between the
asset share and the surrender value.

Capital risk

It is likely that it will take significant amounts of capital to write this line of
business since new business strain is likely to be present during the initial
years of the contract.

The company is likely to deduct from asset shares a charge for the use of
capital.

There is a risk that this charge is set too low to adequately compensate the
other with profits policyholders, if the free estate in the with profits fund is
used to provide the capital support.

If additional capital is required to be provided by shareholders to support the
free assets in the with profits fund to allow the writing of this business, then it
may be that the capital charge is set too low to adequately compensate the
shareholder for this use of their capital.

There is also a risk that the shareholders may not be willing to support the
with profits fund in this way given that they are likely to get their profits back
through, for example, a 90/10 gate.

There is also an opportunity cost risk, in that the capital required may be better
utilised for some other purpose, for example, launching a different product
line (that is not so capital intensive), developing an alternative distribution
channel and so on, that may produce greater investment returns.

Expense and volume risk

There is a risk that the company underestimates the expenses (both
development and regular ongoing expenses) that it incurs to administer the
policy and that have been loaded into the premium charged.

In deriving the expense assumptions, the insurance company will have made
assumptions regarding the likely volume of new business that will be written
as a result of launching this product.

If the company writes less business than expected, then the company may not
recoup the development costs that it has sunk into launching this product.

Again, to an extent, expense risk may be passed on to customers through the
bonus structure.

If the company writes more business than expected then there are two risks.
Firstly, the company may not have sufficient capital to support the writing of
Subject ST2 (Life Insurance Specialist Technical) September 2008 Examiners Report

Page 18
so much new with profits business. Secondly, the companys systems and
operational staff may find it difficult to cope, causing backlogs and complaints
in respect of issuing policies.

There is a risk of a change in the mix of business being different to that
assumed in the pricing, leading to an incorrect expense loading, for example,
premium size.

The inflation assumption used in pricing may have been insufficient resulting
in expenses growing at a faster rate than assumed.

Marketing and competition risk

There is a risk that the company may market or sell the product
inappropriately through certain distribution channels. For example, if the
product is sold through a direct agency force, the agents may exaggerate the
likely returns on the product to potential policyholders to secure a sale. Hence
there is the risk of a mis-selling scandal in the making.

There is a risk that the product may look uncompetitive when compared to
with profits products being offered by the insurance companys competitors.
This could be due to the benefits offered for a given premium, the type of
riders that might be available, or just generally poorer investment performance
resulting in lower bonuses and final payouts to policyholders.

There is also a risk that the product may appear expensive when compared to
other investment options, for example, investing in unit trusts and taking out a
term assurance policy to provide the death benefit.

Even if this product proves attractive, competitors may quickly copy it or
improve the attractiveness of their features thus reducing sales potential.

There is a risk that the company has mis-read the demand in the market and
that either there is no demand for the product, or there is demand, but for a
different type of product, for example, a unit-linked version rather than a with
profits version.

There is a risk that the product is too complex and hence it will be difficult to
train the sales force selling the product and difficult for them to sell/explain
the product to potential customers.

There may be a reputational risk to the company of ceasing the policy in the
event of the childs death.

Administration / Systems issues

There is a risk that the company underestimates the level of IT development
work required to amend the insurers IT systems to be able to cope with the
administration of this product.

Subject ST2 (Life Insurance Specialist Technical) September 2008 Examiners Report
Page 19
This is especially the case if this is the first time that the company has
launched a product that offers multiple benefit payouts, since this may require
complex system changes to cope with this.

If the systems take much longer to amend than expected, it may result in a
delayed launch for the product, which may be harmful if the company has
announced its intention to launch the product.

If administration staff are not adequately trained on the product features
customers may be misled.

In addition, fraud is possible, for example, if the company is not notified of the
death of the child.

Other potential risks include:

changes to the tax or regulatory regimes
concentration or aggregation of risk
general system, data or control failures


END OF EXAMINERS REPORT
Faculty of Actuaries Institute of Actuaries







EXAMINATION


20 April 2009 (pm)


Subject ST2 Life Insurance
Specialist Technical




Time allowed: Three hours

INSTRUCTIONS TO THE CANDIDATE

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

2. You have 15 minutes before 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 the
supervisor.

4. Mark allocations are shown in brackets.

5. Attempt all seven 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 this
question paper.

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


Faculty of Actuaries
ST2 A2009 Institute of Actuaries
ST2 A20092
1 A life insurance company distributes profits to with profits policyholders using the
contribution method.

At the most recent valuation the following information was available for a particular
policy:

Value of contract at 1 J anuary 2008 on valuation basis =20,000
Value of contract at 31 December 2008 on valuation basis =22,000
Gross Annual Premium =1,000 paid on 1 J anuary 2008
Sum Assured =50,000

The valuation basis uses an interest rate of 5% per annum, an annual mortality rate for
this policyholder of 0.002 and an expense assumption of 100 per annum.

The mortality experienced over the year has been 10% lighter than that assumed, with
all deaths occurring at the end of the year. Expenses were 10% higher than assumed,
and were all incurred at the beginning of the year. Interest received over the year has
been 10% higher than assumed under the valuation basis.

Calculate the dividend paid under this contract, defining all symbols used, showing
the formulae used and all workings. [4]


2 Describe how an asset share for a conventional with profits contract may be
determined. [7]


3 A life insurance company sells conventional without profit endowment assurance
contracts.

(i) Discuss why the insurer may offer policyholders the option to make their
policy paid-up. [7]

(ii) Describe the factors that should be taken into account when determining the
paid-up sum assured. [5]
[Total 12]


4 An entrepreneur is considering setting up business in the without profits whole life
assurance second-hand market. This market involves the purchase of in-force
without profits whole life policies from policyholders, who receive a lump sum in
return. The purchaser becomes the legal owner of the policy and pays any future
premiums due to the life insurance company who issued the policy. The purchaser
then receives the death benefit when the original policyholder dies.

(i) Describe the benefits of this arrangement for the original policyholder. [4]

(ii) Discuss the factors that the entrepreneur would have to consider when entering
this market. [9]
[Total 13]

ST2 A20093 PLEASE TURN OVER
5 (i) State the principles of investment that a life insurance company should adhere
to when determining its investment strategy. [2]

A life insurance company has recently launched an annual premium unit-linked
investment contract which must be used to provide policyholders with an immediate
annuity at retirement.

At retirement the policyholder can convert the unit fund into an immediate annuity at
the companys prevailing rates or they can purchase an immediate annuity from
another provider.

If the policyholder wishes to transfer their whole fund to another provider or dies
before retirement, the amount paid out is equal to the value of the unit fund at that
time.

(ii) Describe how the company might invest its assets in order to match all its
liabilities as closely as possible. [6]

The marketing director would like to add a guarantee to the amount of immediate
annuity that can be purchased at retirement using the proceeds of this contract. She
has suggested that the annuity payment should be calculated using a guaranteed
minimum interest rate.

(iii) Discuss the additional risks that the company would face by adding this
guarantee. [4]

(iv) Discuss how the company might change its investment strategy if this
guarantee were added to the contract design. [3]
[Total 15]


6 A life insurance company has been writing immediate annuity business for the past
five years. The company has been successful in writing this business and now has a
large book of annuities in payment. No surrender values are offered on these
annuities.

(i) Describe the risks that the life insurance company faces in writing this
business. [13]

(ii) Describe how the life insurance company should set the annuitant mortality
assumption when setting supervisory reserves. [6]

(iii) Explain why a surrender value is not usually offered on immediate annuity
contracts. [5]
[Total 24]

ST2 A20094
7 A life insurance company sells only immediate annuities.

The level of business sold in recent years has been declining and the company is
considering re-pricing its existing product to improve its competitiveness.

(i) Discuss why the level of business sold in recent years may have been
declining. [4]

(ii) Explain the advantages of using a cashflow approach, as opposed to using a
formula approach, to price the immediate annuities. [5]

(iii) Describe how a cashflow model would be used to price the immediate
annuities. [9]

(iv) Outline the alternatives to re-pricing the product that the company could use to
improve new business volumes. [7]
[Total 25]


END OF PAPER

Faculty of Actuaries Institute of Actuaries











Subject ST2 Life Insurance
Specialist Technical

EXAMINERS REPORT

April 2009





Introduction

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


R D Muckart
Chairman of the Board of Examiners

July 2009




Comments

Comments for individual questions are given in the solutions that follow.








Faculty of Actuaries
Institute of Actuaries
Subject ST2 (Life Insurance Specialist Technical) April 2009 Examiners Report

Page 2
1 Formula:

(V0 + P)(i i)
+ (q q)(S V1)
+ [E(1 + i) E(1 + i)]

Define:

V0 = Reserves at the beginning of the year = 20000
V1 = Reserves at the end of the year = 22000
P = annual premium = 1000
S = sum assured = 50000
i = valuation interest rate = 0.05
i = actual interest rate = 0.05 1.1 = 0.055
q = valuation mortality rate = 0.002
q = actual mortality rate = 0.002 0.9 = 0.0018
E = valuation expenses = 100
E= actual expenses = 100 1.10 = 110

Definitions should be stated in solution.

Giving a dividend of:

[20000 + 1000][0.055 0.05]
+ [0.002 0.0018][50000 22000]
+ [100 1.05 110 1.055]
Dividend = 105 + 5.6 11.05 = 99.55

Note from examiners:

This was a standard bookwork question that was generally well answered.


2 Asset share is accumulation of premiums less the deductions associated with the
contract accumulated at rate of return earned on investments. It may not be possible to
calculate the rate of return earned on investments accurately, so may use the return on
a benchmark index/indices instead. An allowance for profits on without profits
business may be included, if relevant and an allowance for surrender profits from
other with profits business, if any, may also be included.

Deductions include:

Commissions paid
Direct expenses incurred (net of tax)
Cost of benefits (e.g. life cover)
Cost of any options and guarantees
(May be on smoothed basis)
Tax on investment income
Transfers of profit to shareholders
Subject ST2 (Life Insurance Specialist Technical) April 2009 Examiners Report

Page 3
Costs of capital to support contract in early years (could also be a positive
contribution for provision of capital support in later years to other contracts)
Contribution to free assets (could also be a positive contribution from free assets
in some circumstances rather than a deduction)

Asset share is calculated recursively on a year on year basis. All premium and
deductions have to be recorded for each period. Asset share calculations can be done
on an individual policy basis or on group of contracts.

Note from examiners:

This was a standard bookwork question that was generally well answered.


3 (i) An insurer would usually offer policyholders the option to make their policy
paid-up in order to stop the policyholder from surrendering their policy
altogether, and taking a surrender value.

Providing a paid-up option may enable the insurer to differentiate the product
from similar products offered by their competitors making the policy
attractive to potential policyholders by offering the option to make a policy
paid-up.

Conversely it may be necessary to provide the paid-up option to make the
product competitive. Not including a paid-up option is likely, in many
markets, to make a product uncompetitive and hence unattractive to many
potential policyholders. In some cases it may be necessary to offer a paid-up
option in response to a move by competitors to introduce a paid-up option on
similar products.

Pressure from sales channels/sales force may force life insurer into adding a
paid-up option.

There are many reasons why a policyholder may choose to make a policy
paid-up, which the policyholder could not have foreseen at the outset of the
policy:

They may no longer be able to afford to pay the premiums.

e.g. due to a life changing event such as an income drop due to one of a
dual income couple giving up work to stay at home to care for children, or
due to e.g. downsizing and taking a less demanding job on a lower income
as the policyholder has got older. Any sensible example.

Making the policy paid-up in this circumstance, enables the policyholder
to continue to have some life insurance cover (which may be welcome in
the event of the arrival of children), without the need to surrender the
policy altogether.

Subject ST2 (Life Insurance Specialist Technical) April 2009 Examiners Report

Page 4
From the companys perspective, allowing the policyholder to make their
policy paid-up in these circumstances means that the company prevents the
policy from being surrendered (the company may make a loss on surrender,
especially early surrenders), which may be the policyholders only other
viable option and by keeping the policy in-force, albeit in a lower sum
assured, the insurer can offer the policyholder the opportunity to restart
premium payments whenever they can afford to. This option would not be
available if the policy had been surrendered.

The policy may no longer meet the needs of the policyholder and hence there
is no need to continue paying the premiums, but equally the policy benefits are
not immediately needed by the policyholder and so the option to surrender the
policy is not so attractive.

E.g. the policyholder may have taken out the traditional endowment assurance
contract when purchasing a property many years ago. The policyholder may
have since paid off the value of their mortgage and hence has no need for the
death or maturity benefit offered by the policy, but equally has no immediate
need for the surrender value. (Marks given for any sensible example.)

It is possible to make an endowment policy paid-up due to the accumulation of
an asset share during the term (unlike e.g. a term policy).

The insurer will benefit from retaining the funds under management and
changing the policy status to paid-up than the policyholder taking a surrender
value, if the profits expected to be made on altering the policy to paid-up
status are at least equal to those that would be made on surrender.

There is also the added advantage for the insurance company of maintaining a
relationship with an existing customer and whilst the existing policy may not
meet their needs, it will be relatively easy and cheap to market other products
to them.

A policy that offers better value for money e.g. lower premiums for the same
benefits may have been launched in the market, making continuation of the
payment of premiums on this policy unattractive.

Traditional without profits endowment assurances are fairly old fashioned
there may be many more different products on the market e.g. unit-linked
variants and unitised with profits contracts that may more closely meet the
policyholders needs or desire to participate directly in stock market returns. In
these circumstances, it is likely to be more beneficial from the insurers
perspective for the policy to become paid-up rather than surrendered
altogether.

Subject ST2 (Life Insurance Specialist Technical) April 2009 Examiners Report

Page 5
Other reasons why the insurer may offer the option to move to paid-up status
include:

It may be required by local regulations that a paid-up value is offered.

It may be beneficial from a tax perspective for the policyholder to make a
policy paid-up rather than surrendering the policy, in which case the
insurer will be keen to offer such a paid-up option to make their product
more attractive.

PRE The policyholder may expect there to be a paid-up option.

Prevents the need to pay cash out now beneficial if there is a cashflow
problem.

(ii) The paid-up sum assured should be supported by the earned asset share at the
date of conversion to paid-up status, on the basis of the expected future
experience.

From a profit perspective, the profit expected from the policy after its
conversion to paid-up status should be the same as prior to the policy
conversion or the same as the expected amount had the policy originally been
written on its altered terms.

At later durations, the paid-up sum assured should be consistent with the
projected maturity value, allowing for the premiums not received between the
date of conversion to paid-up status and the end of the policy term.

The paid-up sum assured should be consistent with surrender values, such that
the surrender value offered before and after the conversion to paid-up status
are broadly equal.

The conversion to paid-up status can be viewed as the limiting case of a
reduction in the sum assured. Hence, apart from any differences in expenses to
be incurred, the premium after alteration should approach zero as the sum
assured approaches the paid-up sum assured.

The costs of carrying out the alteration should be recovered.

From a practical perspective, the calculations should be straightforward
enough that the administration systems can cope and do the calculations
automatically.

The methodology used to calculate paid-up sums assured should not change
arbitrarily and the paid-up sum assured should not be subject to discontinuities
from year to year (e.g. a sudden jump in the paid-up sum assured due to the
switch from calculating the paid up sum assured on a retrospective basis to a
prospective basis).

Subject ST2 (Life Insurance Specialist Technical) April 2009 Examiners Report

Page 6
The methodology to be used to calculate paid-up sums assured may be
specified in regulations or by the local insurance regulator.

The insurer should take into account policyholders expectations, in the
interests of treating customers fairly the paid-up sum assured should be able
to be explainable to the policyholder.

The method used to calculate the paid up sum assured must be capable of
being documented clearly.

It is likely that the insurer will take into account competitors paid-up benefit
approach.

If any paid-up terms were included in the original policy these should be taken
into account when calculating the paid-up sum assured.

Note from examiners:

Part (i) was generally quite poorly answered with candidates not considering
the benefits to the company of the client keeping the policy in force (maintain
the relationship, funds under management remaining, cross-selling of other
products etc. Part (ii) was generally answered better than part (i) although
many candidates missed standard bookwork points.


4 (i) Selling the policy on the secondhand market is an alternative to surrendering
the policy to the insurance company. A policyholder is likely to consider
doing this if the payment received for the policy on the secondhand market is
greater than the surrender value payable by the insurance company (which
could encourage lapse and re-entry though the difference in value is unlikely
to be sufficiently significant), or if the original policy did not have a surrender
value.

The (enhanced) payment is receivable upfront rather than on death and could
be used to pay medical bills if ill or pay off any loans, such as a mortgage. By
receiving the secondhand market value now the policyholder has reduced the
uncertainty over timing and possibly amount of payment.

By selling the policy on the second hand market, the policyholder receives the
benefit of the policy rather than his/her beneficiaries. The policyholder may no
longer have any beneficiaries so would rather receive the lump sum.
By selling the policy, no future premiums need to be paid by the policyholder,
which may be beneficial if the policyholder can no longer afford the
premiums.

The policyholder may no longer require the policy due to a change in
circumstances.

The entrepreneur may be prepared to pay an enhanced surrender value if the
policyholder can provide evidence of ill-health.
Subject ST2 (Life Insurance Specialist Technical) April 2009 Examiners Report

Page 7
(ii) Profitability

Profitability is dependent on the lump sum paid to the policyholder being
lower than the expected present value of the death benefit received less
premiums paid and expenses incurred.

The lump sum should include allowance for a sufficient profit margin
given the risks the entrepreneur is willing to take.

The entrepreneur should take into account the sensitivity of profit to
variations in the key risk factors.

Setting the assumptions to measure the likely profitability of this business
will be difficult.

Marketability

The lump sum paid to the original policyholder to be in line with those
offered by the competition i.e. other 2
nd
hand policy traders.

The lump sum also has to be competitive when compared to the surrender
value that the life insurance company is willing to offer.

Financing Requirements

There is an issue due to timing differences of income and outgo for the
entrepreneur.

The lump sum payment is paid out to the policyholder on day one,
premiums and expenses are then incurred for a period and then the death
benefit is received later.

Cost of financing the entrepreneur will have to finance the lump sum
payment and there will be a cost associated with that use of capital.

The entrepreneur will need to consider what volume of business he can
afford to write this initial outlay needs to be allowed for in the business
plans.

Risk Characteristics

The primary risk is the mortality of the life assured being lighter than
expected.

Hence underwriting of the life insured is important before determining the
size of the lump sum payment.

Additionally there is a risk that the dependents of the life assured do not
inform the entrepreneur of the death of the assured as there may be no
Subject ST2 (Life Insurance Specialist Technical) April 2009 Examiners Report

Page 8
incentive to do so and so the death benefit is received even later than it
potentially could be received.

This could result in the entrepreneur not having sufficient cash flow to pay
ongoing premiums and expenses.

There is also a risk of random fluctuations i.e. death benefits expected to
be received from life insurers being lower than expected, due to fewer
deaths than expected, simply due to small volumes and random
fluctuations in the results.

Systems

An administration system will have to be set up to pay premiums to the
various life insurance companies.

A system could be built linking to a national database of deaths to ensure
the entrepreneur is aware in a timely manner of deaths. [Marks awarded
for any sensible suggestion regarding the need for a death recording
system.]

Other

Terms and conditions of the policies purchased could vary between the
insurance companies, resulting in potential mis-understanding of policy
benefits.

Any regulatory requirements e.g. an insurable interest in a life insurance
policy may be required which the entrepreneur doesnt have.

The entrepreneur is exposed to the risk of default of the life insurance
company.

The entrepreneur needs to consider the tax implications of setting up this
business.

Target Market

Firstly the entrepreneur need to consider whether there is a big enough
target market.

Then he/she needs to consider who to target, for example could target
those in ill health, in need of the income, or alternatively those in good
health who wish to cash in their policy.

The entrepreneur will need to decide how to advertise and market the
service to the target market.

Subject ST2 (Life Insurance Specialist Technical) April 2009 Examiners Report

Page 9
Mix of business

Ideally the entrepreneur will probably want a mix of ages with the aim of
having death benefit payments spread. The entrepreneur also needs to
consider, if possible, the extent to which insurance companies cross
subsidise e.g. by age, policy size etc., since all policies may not be equally
profitable from an insurance company perspective, which may impact the
payout offered by entrepreneur.

Alternative investments

The entrepreneur will consider the return available on alternative
investments.

The entrepreneur will also consider the possible strategies for exiting this
market e.g. the number of other player and whether likely that would be
able to sell the business in a number of years to a competitor.

Note from examiners:

This question was generally poorly answered with many candidates mis-
understanding the information provided in the question. Stronger candidates
were able to apply bookwork knowledge and thought widely. In part (ii) many
candidates did not discuss profitability and how the entrepreneur would make
profits, and some failed to describe the mismatch in cashflows that the
entrepreneur would experience.


5 (i) Select investments appropriate to the nature, term and currency of its
liabilities.

Select investments so as to maximise the overall return on the assets, where
overall return includes investment income and capital gains.

The extent to which appropriate investments are departed from in order to
maximise the overall return depends on the extent of the companys free
assets.

These investment principles can be expressed also as:

The company should invest so as to maximise the overall return on the assets,
subject to the risk being taken on being within the financial resources available
to it.

(ii) The company will wish to invest in assets that match the nature, term and
currency of the liabilities.

The policyholder benefits can be sub-divided into:

Subject ST2 (Life Insurance Specialist Technical) April 2009 Examiners Report

Page 10
Investment-linked: This consists of the benefits under the unit-linked
contract purchased by premiums paid to date (less charges), the amount of
which is determined directly by the value of the investments underlying
the contracts

All death, retirement and withdrawal benefits are defined in terms of
the unit fund.

Guaranteed in terms of an index: Usually include expenses which tend to
increase and can be treated as being linked to an index for investment
purposes.

Matching investments could be as follows:

Investment-linked

Invest in assets which are the same or similar to those assets used to
determine the benefits.

If not possible then invest in assets linked to a index which closely
matches the performance.

Guaranteed in terms of an index Expenses

As the contract is unit-linked a non-unit reserve will be set up for the
expected difference between future expenses and future charges received.

Expenses are likely to increase related to the salary information of the
country if they are linked to staff costs, or inflation if they are non-staff
costs.

Charges received will be fund related charges and as such will be
dependent on the fund performance.

Try to match expenses less charges cash flow will be difficult in practice
since there are two elements varying at different rates.

In practice likely to invest in index-linked securities but in their absence
assets which provide a real return could be purchased.

Annuity in payment this only becomes a liability at the vesting date if the
policyholder doesnt take the open market option.

If annuity payments are fixed guaranteed amounts, then they will be best
matched by fixed interest securities.

If annuity payments are index linked, then will be best matched by index
linked securities.

Subject ST2 (Life Insurance Specialist Technical) April 2009 Examiners Report

Page 11
The bonds should be of appropriate term and should be in the same
currency as the annuity payments.

There may be practical difficulties, such as difficulties in finding bonds of
sufficient duration or lack of availability of index linked bonds.

(iii) Adding the guarantee exposes the company to the risk of adverse movements
in interest rates between now at the date the policyholder retires.

If interest rates at the time of retirement are lower than the guaranteed rate
then the guaranteed annuity rate may be higher than the prevailing market rate.

A key risk is that the company doesnt charge adequately for the guarantee
provided and the risk associated with the provision of the guarantee.

If the charges for the guarantee are specified as a percentage of the fund value,
then the company is also introducing a market risk that it is now exposed to.

The guarantee will be attractive to policyholders, and could lead to higher
volumes of business and higher volumes could lead to a higher capital strain
that the company cannot afford.

The company should review the guaranteed minimum interest rate
periodically.

If they dont then there is a risk that customers will select the policy when the
guarantee looks attractive (depending on their view of how interest rates may
change).

Including a guarantee introduces a competition risk, since there will be a need
for the guarantee offered to be at least in line with the guarantees offered by
other providers in the market. Failure to do this may lead to a credibility issue
for the insurer in this market.

In addition, there is a risk that the charge for the guarantee may make the
product uncompetitive which may have a knock-on impact on new business
levels.

The onerousness of the guarantee may be increased if policyholders are
allowed to pay in additional future premiums into their unit-linked fund that
receive the same guarantee.

Onerousness of the guarantee is also increased if fund performance is good
since good fund performance will produce a higher unit linked fund with
which to buy the annuity, which will lead to larger guaranteed payments.

There is a risk that the company fails to train admin and sales staff regarding
the guarantee and also a risk that the admin systems cannot cope with the
guarantee.

Subject ST2 (Life Insurance Specialist Technical) April 2009 Examiners Report

Page 12
There is a reputational risk since only the interest rate is guaranteed the
mortality assumption that will be used at the vesting date is not guaranteed.
Hence the company could use a very light mortality assumption in
determining the annuity amount at the vesting date, leading to the policyholder
getting a far lower annuity amount than anticipated, which would lead to poor
perceptions about the guarantee and the value for money provided.

Also, although mortality is not guaranteed, improved longevity over time will
also increase the onerousness of the guarantee as the annuity payment will be
paid for a longer period.

(iv) Now have an additional non-unit liability that has to be matched.

It is not possible to alter the investment strategy during the accumulation
period since this is a unit linked contract and the assets should be held that
exactly match the unit fund liabilities. The insurer needs to find assets which
remove the risk of the guaranteed interest rate between now and the vesting
date.

Interest rate derivatives could be purchased which provide a guarantee to the
interest rate in the future. [Marks awarded for any other alternative sensible
example e.g. swaptions].

There would be a need to keep rebalancing the derivative position over time as
interest rates moved. Also need to keep rebalancing as the expected take-up
rate at vesting will alter over time as will the expected funds under
management at the time of vesting.

There would be a need to charge for the cost of using a derivative programme
to meet the interest rate guarantee.

Note from the examiners:

Part (i) was standard bookwork and was answered well.

Part (ii) was mixed with poorer candidates not understanding how unit linked
policies work and not able to describe the mismatch between expenses and
charges.

Part (iii) was answered poorly with many candidates not stating that the
company was exposed to interest rate risk between now and retirement.
Stronger candidates considered the risks related to the charge for the
guarantee and how this taken. Many candidates did not recognise that the
guarantee was a guaranteed interest rate at retirement, rather than a
guaranteed monetary amount.

Part (iv) was generally poorly answered. Weaker candidates implied that
matching the guarantee with fixed interest assets would be sufficient. A large
number of candidates recognised that derivatives would be appropriate. Only
a few candidates acknowledged that it was likely that there would be an
Subject ST2 (Life Insurance Specialist Technical) April 2009 Examiners Report

Page 13
additional charge for this matching or that there would be a need to
continually rebalance the derivative cover.


6 (i) The risks the company is exposed to are:

Longevity risk

When pricing the contract the life insurance company will have made an
assumption regarding the expected mortality of the annuitants.

The annuity portfolio may suffer generally lighter mortality than allowed
for when the product was priced meaning that the annuitants live for
longer and receive more annuity payments than was expected at the outset
of the contract.

In particular underestimating the rate of improvement of life expectancy
over time is a significant risk.

Mix of business (mortality risk)

We are not told whether the company offers unisex annuity rates or
different rates for males and females. If the company offers unisex rates,
then it is exposed to the risk of the ratio of male to female lives being
different to that assumed when setting the annuity rates.

Generally females tend to live for longer, hence if the life insurance
company writes more business for female lives than the proportion
assumed when the annuity rates were being set then on average, the
annuitants will live for longer than allowed for in the pricing basis.

We are also not told whether the company offers different annuity rates for
smokers and non-smokers. Non-smokers usually exhibit lighter mortality
i.e. they live longer, than smokers.

If the life insurer offers a single set of rates that does not differentiate
between smokers and non-smokers and the company sells annuities to a
greater proportion of non-smokers than allowed for in the pricing basis,
then the insurer will make a loss on this portfolio.

This can be exacerbated by anti-selection risk.

The company may also have allowed for a mix of business by target
market / source of business / geographical location, in pricing which it
may have mis-estimated.

Subject ST2 (Life Insurance Specialist Technical) April 2009 Examiners Report

Page 14
Expense risk

The insurer is exposed to the risk of underestimating the general level of
expenses that it will incur to administer this business.

The insurer is also exposed to the risk that it has underestimated the
expense inflation that it will suffer from during the life time of the
annuitants.

It is likely that there will be cross-subsidies between large and small
policies, and that if the average case size is smaller than assumed during
pricing then the life insurer may not be able to recoup all of the expenses
related to writing this business.

Volume risk

The life insurer is exposed to the risk of writing too little business, which
may result in any development and marketing costs not being recouped
through the expense loadings in the annuities sold.

The life insurer is also at risk from writing too much business, in which
case it may not be able to provide good service to its annuitants e.g.
policies may take too long to set up, payments may be made late and so
on.

This would damage the insurers reputation and may lead to a loss of new
business in future years.

Higher than expected volumes can also cause capital strain, depending on
the onerousness of the regulatory regime.

Mismatch risk

The insurer provides a guaranteed income for life for each annuitant. If the
life insurance company chooses to invest the initial premiums received in
such a way that there is a mismatch between the assets and liabilities for
this contract (e.g. by expected term, nature or currency) or if it is not
possible for the life insurer to invest in assets that match the liabilities (e.g.
because the outstanding duration of the liabilities is too long and assets of
corresponding during are not available) then the insurer is taking an
additional mismatch risk for this block of business.

And there is extra risk if annuity rates are not changed frequently enough
in line with movements in the yields of the matching assets that will be
purchased.

There will be extra risk if use corporate bonds due to default risk.
Subject ST2 (Life Insurance Specialist Technical) April 2009 Examiners Report

Page 15
Marketing and competition risk

Immediate annuities are generally very price sensitive, with a high degree
of competition between insurers to gain market share.

There is a risk that the company may be unable or unwilling to match the
premium rates offered by other insurers in the market or that it does not
monitor market premium rates pro-actively enough, and hence loses the
market share that it has managed to build up over the last 5 years.

There is also a risk of management pressure leading to the company
offering annuity rates that are too high.

In order to be competitive and maintain market share life insurers may try
to offer additional features, such as the guaranteed income of 5% of the
initial single premium, for life, included in this product and so in this
respect the insurer is aiming to market an attractive product.

However, if the insurer has marketed the same immediate annuity product
for the last 5 years, then its competitors are likely to have copied this
feature by now and may be offering more innovative features, making this
life insurers product look outdated.

Other risks

Data problems in particular, the insurer has only 5 years worth of data
which is too short for identifying trends, including delays in notification of
death.

Fraud deaths not notified by family or fraudulent behaviour by insurers
own staff.

Regulatory change e.g. discrimination legislation could mean having to re-
price everything and also could exacerbate anti-selection risk.

Tax changes may affect the relative attractiveness of the product.

(ii) Mortality is the most significant assumption require a prudent valuation and
hence not a best estimate assumption, but one that incorporates margins for
adverse deviations. Need a prudent estimate of the base mortality plus a
prudent estimate of the assumed future mortality improvement rates.

In this case, prudent means a lower percentage of a mortality table for the base
table assumption and prudent means a faster rate of improvement in mortality
(i.e. lower, slower deaths).

Consider the mix of business the insurer shouldnt assume that the
population all comes from areas with heavier mortality.

Subject ST2 (Life Insurance Specialist Technical) April 2009 Examiners Report

Page 16
The principles also state that the reserves should not be subject to
discontinuities arising from arbitrary changes to the valuation basis.

In this case, the life insurer has been writing this business for the last five
years and is likely to have set supervisory reserves for this product in previous
years. Hence the starting point for setting the mortality assumption should be
the assumption made the previous time that supervisory reserves were
calculated.

The insurer will look at any mortality experience studies that it has carried out
since it last set the supervisory reserve mortality assumption to determine
whether the experience suggests that the assumption should be tightened i.e.
lighter mortality should be assumed, or whether the mortality assumption can
be weakened, by assuming heavier mortality than was assumed previously.

The company has only been writing this business for the last 5 years and hence
it has a relatively immature portfolio on which to carry out a mortality
experience analysis.

It is also likely that the company wrote a limited amount of business in the
first couple of years of writing this business, with its market share gradually
increasing. Hence the company is most likely to leave the mortality
assumption unchanged from the previous period when it last set the
supervisory reserves, unless the limited experience investigations show that
mortality has been significantly worse than anticipated for the business on the
books.

The insurer will also take into account the extent to which there is a statutory
guidance that has to be followed in setting the mortality assumption e.g.
regulations may specify the annuitant mortality assumption to be used.

For future mortality improvements, the company is likely to look at external
data sources, such as the latest trends shown in academic studies, data from
consultancies.

The company may also consult the latest pricing work recently carried out to
get the companys latest view on mortality trends.

(iii) A surrender value is not usually offered on annuity contracts due to the
significant anti-selection risk that would exist if an insurer were to offer a
surrender value.

The most likely policyholders that would contemplate surrendering an annuity
product are those who believe that the surrender value they will receive is
more than the value of the regular annuity payments they will receive
throughout the rest of their lifetime. Such policyholders are likely to be those
who e.g. have been diagnosed with a terminal illness, and do not expect to
survive for long to continue receiving the annuity payment. This will result in
those who are left having a longer life expectancy on average.
Subject ST2 (Life Insurance Specialist Technical) April 2009 Examiners Report

Page 17
In addition, at the outset of the contract, when the insurer receives the single
premium payment for the annuity, the insurer will invest all of the single
premiums received for a cohort of business, in such a way that it best matches
the liability of the regular annuity payments. If the insurer were to allow
surrenders, then the pattern of surrenders would be difficult to predict and
cashflow matching would be more difficult. In addition, the company may
also have to sell assets at a time when asset values are depressed (when it was
not expecting to sell assets) in order to pay the surrender values. Hence by not
allowing surrenders, the insurance company is limiting the investment risk is
would otherwise be exposed to in respect of surrenders.

By not offering a surrender value, the insurance company removes this risk of
surrender and re-entry and the customer dissatisfaction that would be likely to
occur if it allowed surrenders in this circumstance.

Regulators/the State may want to discourage surrender values from being
offered since they may want the annuities to remain in payment.

The life insurer would require underwriting evidence if someone wanted a
surrender value either the policyholder would have to provide documentary
evidence of ill-health or the insurer would have to arrange for medical exams
etc. likely to lead to customer dissatisfaction.

Note from the examiners:

Part (i) was generally well answered. Stronger candidates considered the
impact of mix of business, whilst weaker candidates suggested that surrenders
and withdrawals were a risk on annuity business.

Part (ii) was poorly answered with many candidates stating standard
bookwork on mortality investigations which wasn't what the question had
asked for. Only a few candidates recognised that a mortality assumption
would already exist for this business and that reference should be made to the
previous statutory valuation.

Part (iii) was generally poorly answered with many candidates not
considering investment issues or adequately explaining the anti-selection risk.


7 (i) Possible reasons why the business levels may have been declining include:

There may have been a number of new entrants entering the market offering
aggressive rates in order to obtain market share. Existing competitors may
have decided that immediate annuities is a business line of core importance to
their strategy and they may have increased the competitiveness of their rates.

All serious players in the annuity market are likely to frequently re-price their
annuities and hence the life insurance company in question may be
uncompetitive because they have been too slow to react to their competitors
active re-pricing strategies.
Subject ST2 (Life Insurance Specialist Technical) April 2009 Examiners Report

Page 18
There may be increased availability of alternative types of annuities, such as
impaired life annuities, offering differentiated rates for smokers etc., which
will provide better rates to smokers than a single set of annuity rates based on
the total population.

There may also be increased availability of more sophisticated products such
as drawdown products that allow the annuity to be drawn down in tranches,
rather than locking into a fixed rate on a retirement date.

Competitors may also have launched with profits annuities, resulting in
declining sales for traditional immediate annuities.

Company performance on unit-linked/with profits annuities could have been
poor, which could lead to potential customers going elsewhere.

There may have been legislative changes meaning that e.g. immediate
annuities no longer have to be compulsorily bought at retirement.

There may have been fiscal changes resulting in immediate annuities no
longer being attractive from a tax perspective.

The company may be perceived to be financially weak, which especially in the
current stock market conditions, may impact business volumes.

The company may have a poor reputation for reliable payment systems or poor
customer service, which has impacted on its sales volumes.

The company may generally have been poor at marketing/have spent little on
brand awareness, which may have resulted in declining sales.

Competitors may offer better commission levels.

Economic downturn policyholders may put off retiring, leading to lower
volumes.

Economic downturn volumes may remain the same but fund values have
fallen, hence the average case size is now lower, leading to lower overall
volumes in production terms.

(ii) A cashflow approach would be preferred as it has the following desirable
features:

It enables the company to measure the expected return that the providers of
capital will receive.

The sensitivity of the profit to variations in experience can be investigated so
that appropriate margins can be determined for the parameter values.

Explicit allowance can be made for the need to set up reserves and meet
solvency requirements.
Subject ST2 (Life Insurance Specialist Technical) April 2009 Examiners Report

Page 19
The cashflows can be used to assess the financing requirements for a new
annuity contract, by using them to build a model of the expected new business.

By incorporating them into a model of the existing business, the impact of the
financing requirement on the company as a whole can be investigated.

Two-dimensional annuity tables can be dealt with when using a cashflow
approach, allowing for % of the base table varying by age, and levels of
mortality improvements varying by age.

A cashflow approach can more easily cope with complex benefit structures, in
particular where benefits depend on future assumptions. This could be useful
e.g. if the company was considering introducing with profits annuities.

It is easier to incorporate assumptions that vary over time, including stochastic
assumptions, for example, investment return or expense.

The risk discount rate can take account of the term structure of interest rates.
Tax can be allowed for more appropriately.

Using the formula approach may be considered too simplistic for a price
sensitive product.

(iii) A model can be used to determine immediate annuity rates that will meet the
companys profit requirement. A number of model points will be chosen to
represent the expected new business under the product. The model points
should cover the full range of chosen rating factors for the annuities, e.g. age
and sex. Since this is an existing product, the profile of the existing business,
modified to allow for any expected changes in the future, can be used to obtain
the model points.

For each model point, cashflows would be projected. These would be annuity
payments, expenses, investment earnings and allowing for reserves and
solvency margin requirements, on the basis of a set of base values for the
parameters in the model, e.g. best estimate.

The projected cashflows will then be discounted at a rate of interest, the risk
discount rate that allows for the return required by the company, and the level
of statistical risk attaching to the cashflows under the product. In theory, a
separate risk discount rate should be applied to each separate component of the
cashflows, as the statistical risk associated with each component will be
different.

The annuity rate for the model point can then be set so as to produce the profit
required by the company. The annuity rate produced needs to be considered
for marketability. This may lead to reconsideration of e.g. the product design,
the distribution channel used, to improve profitability. There will be an
iterative process, with the models being rerun once the design of the product
and the distribution channels etc. have been reconsidered.
Subject ST2 (Life Insurance Specialist Technical) April 2009 Examiners Report

Page 20
The cashflows in respect of the model points, appropriately scaled up for the
expected new business under the product, will be incorporated into a model of
the business of the whole company in order to look at the impact on
profitability and solvency of selling the product. If capital is a problem then
the impact of writing the product will be assessed by looking at the timing and
the amount of the cashflows. It is possible for the desired level of profitability
to be reached in aggregate, without requiring every individual model point to
be profitable in its own right. If certain model points are unprofitable then the
aggregate profitability of the business is then exposed to changes in the mix
and volume of the product sold.

Once acceptable annuity rates have been determined for the model points,
annuity rates for all contract variations can be determined.

The company would carry out sensitivity runs to test the sensitivity of the
profits to changes in the main assumptions.

(iv) Rather than re-price the annuity, the company could look at other alternatives
to increase new business volumes. These could be:

(a) Alternative distribution channels, where a change in the sales
distribution channel may result in a change to the targeted market, or a
change to the number of potential customers that are introduced to the
product.

(b) Alternative product design e.g. add in capital repayment guarantees or
offer impaired life annuities if not already offered or other variations
such as unit-linked or with profits annuities.

(c) Alternative products where the company looks at selling alternative
products to the immediate annuity. These products might be more
attractive than the immediate annuity to the target market.

(d) A targeted marketing campaign where specific groups of individuals
are specifically targeted to increase the take up rate of the product.

(e) Promotions, e.g. increased advertising. In particular this could be to
counter e.g. any recent adverse publicity due to share price falls or due
to perceived financial weakness.

The company could also look to promote its improved customer
services with some of its sales channels if it has had a poor reputation
for customer service in the past or via free gifts or incentives or
sponsorship to generate increased brand awareness.

Marketing could be increased on the product to raise awareness in the
target market or in the distribution channel used to sell the product.

The insurer could directly target employers with pension schemes.

Subject ST2 (Life Insurance Specialist Technical) April 2009 Examiners Report

Page 21
(f) Lobbying of Government / regulator

If the market as a whole is not very active, then it may be possible for
the company to lobby the Government or regulator to change the
regulations to improve the competitive nature of the product, by
changing the tax rules applying to the benefit received, or premium
paid.

(g) Consider using reinsurance (if not using already), or changing existing
reinsurance arrangements to improve terms.

Note from examiners:

This question was generally well answered, with parts (ii) and (iii) being standard
bookwork questions. Part (i) was generally well answered although many candidates
did not fully consider the impact of other annuity products being available in the
market.


END OF EXAMINERS REPORT
Faculty of Actuaries Institute of Actuaries







EXAMINATION


29 September 2009 (pm)


Subject ST2 Life Insurance
Specialist Technical




Time allowed: Three hours

INSTRUCTIONS TO THE CANDIDATE

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

2. You have 15 minutes before 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 the
supervisor.

4. Mark allocations are shown in brackets.

5. Attempt all seven 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 this
question paper.

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

Faculty of Actuaries
ST2 S2009 Institute of Actuaries
ST2 S20092
1 (i) List the requirements that an actuarial model should satisfy. [4]

(ii) Describe the basic features of an actuarial model for projecting life insurance
business. [4]
[Total 8]


2 (i) Describe the risks to which a life insurance company is exposed with regard to
policy data. [3]

For several years, a life insurance company has sold unit-linked life insurance
contracts. The analysis of surplus performed by the company has indicated a large
unexplained loss. It has been suggested that there may be errors in the data extraction
process.

(ii) Describe the steps that the company should take to ensure the data was
accurate and appropriate. [6]
[Total 9]


3 A small but growing life insurance company writes only term assurance business. It
currently reinsures 80% of claims payments using a quota share arrangement. It is
considering stopping using this arrangement.

(i) Suggest reasons why it may choose to do this. [3]

(ii) Describe how the proposal may change the risk profile of the company. [4]

(iii) Discuss how the company may seek to mitigate the increased risks. [5]
[Total 12]


4 (i) Describe the attributes of the four main distribution channels open to a life
insurance company. [7]

(ii) Describe the costs that would be incurred by a life insurance company that
uses each of these channels. [4]
[Total 11]


5 A life insurance company sells, and has only ever sold, unit-linked endowment
assurance contracts.

(i) Describe the main features of these contracts. [5]

The economy in which the company operates has just gone into recession.
Unemployment is rising and house prices are falling.

(ii) Discuss how these conditions may impact its unit-linked business. [5]
[Total 10]

ST2 S20093
6 Company Z sells individual unit-linked endowment assurances for the purposes of
retirement planning. This is a large market in the country in which Company Z
operates. Under local regulation policyholders are able to transfer their policies
between life insurance companies, investing their existing fund plus future premiums
into the unit-linked investment funds available from the new provider. These transfers
are largely initiated by insurance intermediaries.

Company Z is looking to be more active in this transfer market and therefore wishes
to enhance its current product in order to be more competitive. It believes this will
enable it to attract more transfer values from other companies.

(i) Describe the key considerations for Company Z when designing the enhanced
product. [13]

(ii) Discuss ways in which the company could reduce its exposure to withdrawal
risk for this enhanced product. [5]

Some life insurance companies offer a guarantee within their unit-linked endowment
assurance products. The guarantee provides a minimum level of immediate annuity
that the fund will provide at retirement. The guarantee is given in terms of a
minimum fixed monetary amount per annum. This guarantee in respect of the
existing fund remains when the fund is transferred between providers. The guarantee
must be maintained by the company the policyholder is with at their standard
retirement age (a fixed date). However the guarantee does not apply to future
premiums paid after the transfer.

(iii) Discuss the main additional risks to the company when accepting a transfer
value that includes a guaranteed minimum annuity amount. [4]

(iv) Discuss how the company could manage the risks described in part (iii). [5]
[Total 27]


7 (i) Define the embedded value of a life insurance company. [2]

A proprietary life insurance company has written conventional with profits,
conventional without profits business and unit-linked business over a number of
years.

(ii) Describe the calculation of the embedded value for this company. [You do not
need to include details of modelling approaches, data or assumptions] [7]


(iii) Discuss how the assumptions used to calculate the embedded value are likely
to compare with those used to calculate any supervisory reserves. [14]
[Total 23]


END OF PAPER
Faculty of Actuaries Institute of Actuaries
Faculty of Actuaries
Institute of Actuaries




Subject ST2 Life Insurance
Specialist Technical

September 2009 examinations

EXAMINERS REPORT




Introduction

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

R D Muckart
Chairman of the Board of Examiners

December 2009

Comments for individual questions are given with the solutions that follow.
Subject ST2 (Life Insurance Specialist Technical) September 2009 Examiners Report
Page 2
1
(i) Models will need to satisfy the following requirements:
The model must be valid for the purpose to which it is being put.
The model must be rigorous and adequately documented.
The model points chosen must reflect adequately the distribution of the
business being modelled.
The parameters used must allow for all those features of the business being
modelled that could significantly affect the advice being given.
The inputs to the parameter values should be appropriate to the business
being modelled and take into account the special features of the company
and the economic and business environment in which it is operating.
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.
However, the model must not be overly complex so that either the results
become difficult to interpret and communicate or the model becomes too
long or expensive to run.
(ii) A model for projecting life insurance business needs to allow for all of the
cashflows that arise. These will depend on the nature of the contract, in terms
of its premium and benefit structure and any discretionary benefits, such as
non-guaranteed surrender values.
It also needs to allow, where appropriate, for the cashflows arising from any
supervisory requirement to hold reserves and to maintain an adequate margin
of solvency.
The cashflows need to allow for any interactions, particularly where the assets
and the liabilities are being modelled together.
The potential cashflows need to allow for options under the business being
modelled, for example, health options such as being able to effect a new term
assurance without the need for further evidence of health.
Where appropriate, the use of stochastic models and simulations need to be
allowed for in order to assess the impact of financial guarantees.
The time period for calculating the cashflows in the projection needs to be
chosen bearing in mind that:
the more frequently the cashflows are calculated the more reliable the
output from the model.
the less frequently the cashflows are calculated the faster the model can be
run and results obtained.
The projection period will need to be considered, depending on the use to
which the model will be put.

Subject ST2 (Life Insurance Specialist Technical) September 2009 Examiners Report
Page 3
Both parts of the question were standard bookwork, candidates generally found part (i)
straightforward. Part (ii) was less well answered where the most common mistake made
by candidates was to replicate part of the answer from part (i).

2
(i) Policy Data Risks
The main actuarial reason for needing policy data is so that a regular valuation
of the liabilities can be carried out, usually, but not exclusively, for insurance
supervisory purposes.
The life insurance company will maintain this data and the actuary carrying
out a valuation will not, usually, have a direct control over them.
There is, therefore, a risk that the company will not maintain the adequate
records required by the actuary and hence the result of the valuation will not
itself be accurate.
Data records may have been recorded inaccurately (i.e. containing errors), or
they may not be complete or may be out of date. This may lead to incorrect
benefit payments being made, which, in turn, may lead to customer service or
regulatory issues.
A similar point relates to policy data required for any internal investigations
carried out by the actuary in order to give appropriate advice to the company.
For some investigations a model of the whole or part of the business of the
company may be used (e.g. the use of model points). There will be a risk that
this model does not adequately represent that business.
There is a risk that any data extraction routines used may be wrong.


(ii) Policy Data Checks
A reconciliation of the current data with those used for the previous analysis
can be attempted. The data are first grouped in some sensible way, for
example, by year of entry within each broad contract type.
Using data similarly grouped relating to business that has come onto the
companys books and gone off between the dates of the two investigations, the
following check is made for each group:
Data at previous investigation + business on business off = data at current
investigation.
The above can check the following items of data:
the number of contracts;
the number of units actually allocated sub-divided by fund;
current premium payable;
current benefits available, e.g. amount of death cover.
Subject ST2 (Life Insurance Specialist Technical) September 2009 Examiners Report
Page 4
The reconciliation also needs to allow for items such as:
changes in the number of units allocated arising from switches between
unitised funds.
changes in the premium payable and benefits under existing contracts.
The movements data should in addition be checked against any appropriate
accounting data, especially with regard to benefit payments, for example:
A check that the numbers of units purchased by premiums and encashed to
pay benefits are consistent with the corresponding revenue account items.
A check that internal unit movements, for example charges and
encashments, are consistent with the surplus emerging during the year.
Checks should be made for any unusual values, for example:
very large or zero unit values;
impossible dates of birth or retirement ages or start dates.
As well as looking at individual values, it may also be possible to group items
and look at how well distributed they are. For example, an unusually high
clustering of birth month may represent a data input error worthy of further
investigation.
It is good practice to compare an extract of the computer held data with the
information in the paper administration files. This can be done on a spot
check basis by randomly selecting a number of policies.
A check should be made to see if there have been any changes to the data
extraction process or the system holding the data that might have affected the
information provided.

Answers to part (i) were reasonable, most candidates were able to identify the main
issues, but did not then link that in to the risk of using the data. Part (ii) was typically
well answered, with most well prepared candidates able to generate a variety of checks
that could be employed.

3
(i) Reinsurance normally passes a share of the profits from the business to a third
party. The company may wish to keep a larger share of the profits. In
particular rates applied by reinsurers may have hardened thus increasing the
cost to the life insurance company and reducing its profits further.
The company is growing and may now feel it has a diverse enough portfolio to
be able to accept more risk.
It may have taken out reinsurance to get support on pricing and other aspects
and may now feel it has enough experience to manage such a process on its
own.
The company may have increased its risk appetite and as such is prepared to
take more risk.
Subject ST2 (Life Insurance Specialist Technical) September 2009 Examiners Report
Page 5
The tax or regulatory treatment of reinsurance may have changed, hence
reducing the attractiveness of the arrangement to the insurer.
The company may have concerns over the solvency of the reinsurer or have
had a commercial disagreement with the reinsurer.
The financial strength of the company may have improved, so it may be more
able to withstand adverse events and/or need less financing commission.
(ii) The company will be exposed to the full amount of claims. This will increase
the volatility of its experience and will lead to more volatility in its profits.
It also means that the company is much more exposed to risks from large
individual sum assureds, concentrations of risk, catastrophes and large random
fluctuations, which could jeopardise solvency, particularly since the company
is still small.
As reserving bases are normally stronger than pricing bases, term assurance
usually requires reserves to be set up in respect of future claims. Solvency
margins are also required as a percentage of reserves and sum at risk.
Removing reassurance will increase both reserves and solvency margin
requirements. This would increase any pressure on the companys solvency
position.
Even if solvency is not an issue, the proposal may also constrain the
companys ability to grow its new business due to the increased new business
strain, particularly if the reinsurance arrangement included financing
commission.
Pricing risk may be increased, if the reinsurer has been providing technical
support.
On the positive side the reduction in reinsurance will reduce the counterparty
default risk to which the insurer is exposed.
(iii) Claims fluctuations may be managed by limiting the size of individual policies
for new business. In particular, it may choose to market fixed size policies to
encourage a spread of smaller policies.
It may also be managed by ensuring a spread of business by geographical
region and / or occupation.
The company may also choose to increase its profit margins, in respect of the
additional risk taken on, through its premium rates, or by introducing
reviewable premiums.
The increased reserving issues may be controlled by different forms of
reinsurance. The company may take out excess of loss cover, catastrophe
reinsurance, or stop loss cover. Rather than reinsuring claims the company
may seek financing reinsurance to reduce capital strains.
Equally it may seek a further capital injection from its shareholders if it can
demonstrate the returns from taking on this extra risk.
More generally the experience can be managed through tighter underwriting.
In particular, larger policies may be heavily underwritten to ensure only the
lowest risk policies are accepted. In addition the company may add additional
premiums to cases deemed higher risk.
Subject ST2 (Life Insurance Specialist Technical) September 2009 Examiners Report
Page 6
It may also diversify its risk through introducing new product lines.
The company may use other sources of information (e.g. industry statistics or
its own experience) to mitigate any pricing risk.

Part (i) was well answered, a few candidates failed to read the question and subsequently
provided an answer to why companies reinsure. Part (ii) was adequately answered with
better candidates able to provide a spread of impacts from removing reinsurance. Part
(iii) was less well answered better candidates provided structured answers based on the
risks identified in part (ii).

4
(i) Insurance Intermediaries (IFAs)
These are independent of any particular life insurance company. They aim
to find the best terms available to clients through either better benefits or
lower premiums.
Often the client will initiate the sale by making contact with the IFA.
However once an IFA has a customer on their books they may instigate
reviews, which lead to repeat business.
Tied Agents
These are salespeople who are tied to one or a few insurance companies.
They may be an employee of a bank or other financial institution.
Often the client will initiate the sale with this channel, drawn in by
advertising in or outside high street branches.
However, such agents may try to actively promote their insurance product
e.g. to customers paying in deposits into bank accounts.
Own Sales force
These are employees of an insurance company so only sell their products.
Here the sale is often initiated by the seller who actively builds his own
client list.
However, once a relationship is established clients may approach the seller
with repeat business.
Direct Sales
These may be through a variety of media including mail shots, telesales,
press adverts and internet.
In the case of mail shots it is the company who initiates the sale. In the
case of others it may be a blend of client or company.
Products in this channel tend to be simpler as there is less direct contact
with the client to make explanations.
Subject ST2 (Life Insurance Specialist Technical) September 2009 Examiners Report
Page 7
(ii) The main cost associated with IFAs is the commission payable in respect of
sales. There may also be an element of internal cost managing IFA
relationships. Increasingly, instead of by commission, IFAs are paid a fee
directly by their client. However, the cost to the company is likely to remain
the same as the commission allowance is likely to be applied back to the
clients product.
With Tied Agents there may be some fixed overhead cost internal to the
insurance company in the form of relationship management support. The
primary cost is however commission payable to the tied agent based on sales.
With a Direct Sales Force the main cost of this channel is the cost of the sales
force itself. This has a fixed element including a base salary and other benefits
such as pension and national insurance contributions as well as the cost of any
office space. It also normally has a variable element being commission /
bonus payable on sales performance.
The costs associated with the Direct Sales channel depend on the type of
media used. They range from the cost of setting up and maintaining a website,
the staff cost of a telesales team or, as with the other channels, the costs of
producing and publishing marketing materials and mail shots.
Ongoing maintenance costs for all channels will include premium collection,
policy administration and policyholder/adviser communication.

Both parts of the question were well answered. A number of candidates included details
of costs in both parts whilst candidates obtained the marks for part (ii), this
undoubtedly wasted time in the exam.

5
(i) An Endowment Assurance contract acts as a savings contract and provides a
benefit on survival to a defined date. It normally also provides a benefit on
death during the contract term. It therefore also operates as a protection
contract for the life assureds dependents.
The savings benefit is linked to returns on assets that the premiums paid are
invested in. The customer can choose from a range of available unit funds, and
takes the investment risk.
The death benefit may be higher than the underlying value of the investments
giving rise to a mortality risk to the insurance company. This is normally
charged for directly as a fraction of the at risk amount payable by unit
deduction.
Other charges are taken to cover the companys expenses including ongoing
administration and fund management. These are normally taken via a
combination of a level annual management charge, a bid/offer spread,
premium allocation rates and monthly unit deductions.
Alternative charging structures include an initial charge payable to cover set
up costs including commissions. However for marketing reasons such charges
Subject ST2 (Life Insurance Specialist Technical) September 2009 Examiners Report
Page 8
may be avoided giving rise to some risks from early surrenders that may be
loaded into the overall annual management charge.
Normally the value of the unit fund is payable on withdrawal part way through
the contract term. This may be reduced by a surrender penalty in early years in
particular if the set up costs are recouped out of ongoing annual management
charges.
Often premiums are payable regularly (normally monthly) but there may also
be single premium contracts available.
There may be riders such as waiver of premium on sickness or unemployment.
(ii) As unemployment is high there are less people in work, which reduces the
number of people who can afford to take out assurance products. This is likely
to be compounded by confidence of those who are in work being knocked by
the economic situation. They too may be less willing to take out insurance
products.
There may be more waiver of premium claims (if rider benefit available) as a
result of unemployment or sickness (e.g. stress related).
If house prices are falling it is likely to reduce the number of people buying
houses. As endowment assurances may be used to back a house purchase this
may also reduce the potential market for sales.
Overall sales of the product are likely to be lower.
In addition, the higher unemployment is likely to lead to a number of people
struggling to keep up with regular bills. This may lead to people stopping
making regular payments into their policy and use premiums for other bills, or
fully surrendering their policy (e.g. if house is repossessed). The reduced
premiums and higher surrenders will reduce the level of income the company
receives through charges.
The economic conditions may well include falls in the values of investments,
which will compound this problem if some of the company revenue is through
an annual management charge and linked to market values.
In addition losses may be made on early lapses if charges not recouped
upfront.
Falls in stock market prices will also reduce investor confidence and unit-
linked products may become less popular.

Part (i) was well answered, with most candidates able to provide a wide spread of points.
Part (ii) was adequately answered, with most candidates linking unemployment with the
ability to pay premiums.

6
(i) Profitability
meet shareholders required return on capital.
cover initial development costs and other expenses.
Subject ST2 (Life Insurance Specialist Technical) September 2009 Examiners Report
Page 9
profit per contract x volumes is important, as well as required profit
margin on each policy sold.
initial development costs likely to be low as enhancing an existing product
(e.g. no new major system development costs or new marketing literature).

Marketability
The level of intermediaries commission will be important in this market
as the market is highly competitive and transfers are initiated by
intermediaries.
Need to consider whether to pay commission as initial or renewal
commission on regular premiums received in the future.
Need to consider what is to be the differentiator to make product attractive
in competitive market. For example, a good range of investment funds
available.
The company is already a player in the unit-linked endowment assurance
market and so is unlikely to need to increase its brand awareness.

Competition
Consider products offered by competitors and whether they have products
targeted at the transfer market.
Consider the charges and commission offered by the competition.
Financing requirements
Wish to minimise financing requirements.
Low new business strain as receiving single premium on day one, which is
likely to cover policy, set up costs and initial commission.
Need to consider risk characteristics
Due to the nature of the market there is a risk of higher transfer rates on
this business, especially in the early years, which would likely result in a
significant loss of future profits.
There is a potential risk of mis-selling.
There is a need to consider any guarantees offered, e.g. as part of the death
benefit.
Need to consider sensitivity of profit
Company would not want profits being too sensitive to changes in
experience.
Unit-linked product so profit will be dependent on charges received and
commission/expenses incurred.
The sensitivity of profit to policy size could be reduced by varying the
charges with the size of the initial transfer value.
Subject ST2 (Life Insurance Specialist Technical) September 2009 Examiners Report
Page 10
Could also reduce sensitivity of profit by having variable fund charges, but
this then reduces marketability.
Consistency with other products
The initial transfer value is likely to be larger than initial premiums
received from new endowment assurance business and as such lower
charges can be offered.
If the company is offering additional enhancements to attract business
from other companies, then the company will have to consider whether
this is fair to genuine new policyholders who would be on less attractive
terms.
If the enhanced terms are to be offered to new customers there is a need to
consider the impact on the existing book of policies.
Other considerations
Large volumes of transfers will potentially have an impact on
administration staff and their ability to cope.
Extent of cross-subsidies. As the company is targeting transfer business,
by definition, there are going to be few cross-subsidies.
The company will have to consider any regulatory or tax requirements.
(ii) Addition of sufficiently high transfer penalties in the early years to discourage
policyholders from transferring their policy.
Addition of a loyalty bonus to the product to encourage the policyholder not to
transfer the contract, for example, lower charges once the policy has been in force
for a number of years.
Recovery (or claw back) of a portion of the initial commission when the policy
transfers in early years.
Trail commission, for example, commission not paid on day one but instead paid
over the policy lifetime dependent on fund size or dependent paid at time future
premiums are received.
Monitor persistency by intermediary and offer enhanced terms for those with good
persistency. Maintain a list of intermediaries the company does not want to do
business with due to past exceptionally high turnover of business.
Monitor persistency frequently and update experience assumptions in pricing and
valuation models appropriately.
Put in place a customer retention team to speak to customers when they initially
request to transfer away from the company.
Improve customer service so customers do not want to leave.
Improve marketing and branding of the company so customers do not want to
leave.
Reduce the opportunities for the policyholder to lapse, for example, ensure any
future ongoing premiums are received through automated premium collection.
Subject ST2 (Life Insurance Specialist Technical) September 2009 Examiners Report
Page 11
Reduce the policyholders incentive to switch by having more competitive
benefits and charges than its competitors.
(iii) Policyholder funds at retirement are insufficient to purchase an immediate annuity
at the guaranteed level so company has to bear the strain. The company may not
have sufficient capital available to bear the strain, but reserving requirements
mean the company will have to reserve for a guarantee at retirement, so sufficient
capital should have been set aside.
The strain may be due to annuity conversion rates moving against the company
over time. Either through lower interest rates at retirement compared to those
assumed when accepting the guarantee; or improved longevity assumptions
resulting in lower annuity conversion rates; or the unit-linked endowment
investment funds performing poorly over the lifetime of the policy; or volatile
fund performance close to retirement resulting in insufficient policyholder fund
value at retirement to provide for the guarantee.
The policyholder fund may only be sufficient to provide for the guaranteed
annuity and no additional annuity, leading to bad press.
Anti-selection risk if pricing terms for accepting the guarantee are less than
competitors.
There may be reputational risk through alleged mis-selling if a guarantee is lost
(e.g. on future premiums) and policyholders do not immediately realise they have
lost it.
(iv) Split the transfer value into the proportion deemed to be backing the guarantee and
the non-guaranteed proportion. Apply higher charges on the transfer value relating
to guaranteed minimum annuity to meet the cost of the guarantee.
Apply an additional loading to the risk discount rate used in pricing to reflect the
extra risk.
Offer a restricted fund choice for the transfer value required for the guaranteed
minimum annuity. For example, less volatile funds with a high fixed interest
backing.
Apply automatic switching into less volatile funds close to retirement on funds
backing the guaranteed minimum annuity.
Require a minimum amount of transfer value before accepting guaranteed annuity.
Not accept business with the guaranteed minimum annuity or from companies
previously offering generous guarantees. Not accept business with the guaranteed
minimum annuity when policy has less than a certain number of years before
retirement.
Use derivatives to remove the investment related risk or longevity swaps to hedge
the mortality risk.
Reinsure the guarantee with an external reinsurer.
The potential reputational risk can be avoided by appropriate disclosure at the
point of sale and with appropriate sales training.
The company could consider buying out the guarantee from policyholders at the
point of transfer.
Subject ST2 (Life Insurance Specialist Technical) September 2009 Examiners Report
Page 12

Part (i) was reasonably answered, most candidates structured their answers around the
appropriate headings but then failed to go into sufficient detail. Part (ii) was a relatively
straightforward question, however a number of candidates failed to score highly. Very
few candidates included persistency monitoring in their answers. Parts (iii) and (iv) were
poorly answered, in part (iii) at best most answers only briefly mentioned lower interest
rates, longevity risk and poor fund performance. In part (iv) a number of candidates
concentrated on the matching of the annuity payments and expenses once the annuity was
in payment, which was not required.

7
(i) Embedded Value is the present value of future shareholder profit stream from
existing business plus the value of any net assets attributable to shareholders.
(ii) Components of EV are
Shareholder share of net assets
Net assets = excess of assets over those required to cover liabilities.
Assets valued at market value, they may be discounted to allow for the lock in
of any assets required to cover solvency requirements.
Present value of future shareholder profits arising from existing business
The process is similar to performing a profit test, except that some items will
not be required (e.g. new business expenses).
Conventional without profit business
For without profits business the embedded value is effectively the release of
margins within the solvency reserves relative to the assumptions used within
the embedded value calculation. The embedded value is
Present value of future premiums plus investment income;
Less claims and expenses;
Plus release of solvency reserves.
Where these must be consistent with those used in the determination of the
net assets (e.g. whether they do or do not include solvency capital in
addition to basic reserves).
Unit-linked business
The embedded value is
Present value of future charges, including surrender penalties;
Less expenses and benefits in excess of unit fund;
Plus investment income on non-unit reserves;
Plus any release of any non-unit reserves.
Conventional with profits business
The embedded value is
Subject ST2 (Life Insurance Specialist Technical) September 2009 Examiners Report
Page 13
Present value of any future shareholder transfers, e.g. as generated by
bonus declarations.
For all business: allow for tax as appropriate
(iii) The present value of future profits (PVFP) calculation will require both
experience assumptions and reserving assumptions. The reserving assumptions
used to determine future supervisory reserves in the PVFP calculation should
be consistent with those used to determine the supervisory reserves in practice.
The assumptions for supervisory reserves may be prescribed by regulation,
whereas embedded value assumptions are unlikely to be prescribed. For the
experience basis in the PVFP calculation, the assumptions will depend on the
purpose of the embedded value. If published in accounts then the experience
assumptions will have to comply with accounting principles rather than the
principles applying to supervisory reserves, for example, whether it is to be
done on a going concern basis or a break-up basis.
If the embedded value is part of an appraisal value calculation, then the
assumptions depend on whether it is being calculated by the buyer (high
margins of prudence) or the seller (ambitious assumptions).
Generally however embedded value experience assumptions will remove some
of the prudence within the supervisory reserves.
For example:
Mortality
Mortality assumptions are likely to be closer to best estimate of future
mortality than supervisory reserves, i.e. for protection policies this would be
lower mortality and for annuities would be higher mortality or lower mortality
improvements on annuities.
Expenses
Expense assumptions in the supervisory reserves will include a margin over
best estimates; embedded value assumption will remove this margin to some
extent. Expense inflation is likely to be best estimate of future inflation in the
PVFP, whereas the supervisory reserves assumption is likely to be higher.
Persistency
It is likely that supervisory reserves will not allow for any assumptions
regarding lapses, going paid up or surrenders, unless to do so would increase
reserves. For PVFP, specific assumptions will be made for lapses, paid ups
and surrenders by product group and by duration.
Commission
Commission will be allowed for as paid, i.e. the same as for the supervisory
reserves. Within the PVFP the value will allow for commission claw back, if
this is a feature of the remuneration, whereas it is unlikely to feature in the
supervisory reserves given lapses are unlikely to be assumed (and if they are,
the value of potential claw back may instead be considered an asset).
Investment returns
Subject ST2 (Life Insurance Specialist Technical) September 2009 Examiners Report
Page 14
Supervisory reserves are determined by discounting future liability cashflows
using a risk-adjusted yield based on the assets being used to back the liabilities
with a prudent margin built in. The prudent margin is deducted from the
discounting yield for supervisory reserve calculations.
The yield permitted may only be based on income and not on total investment
return including gains.
For the PVFP calculation, two different types of investment return
assumptions are required: one to project investment returns into the future and
one to discount the future profits (the risk discount rate). Projected future
investment returns within the PVFP calculation will be based on the total
expected return and are unlikely to include any material prudent margins.
A company may set a unit growth rate for unit linked business, based on the
best estimates of returns on the assets held to back the unit funds this is
likely to be higher than the assumption used for supervisory reserves.
The risk discount rate used for the PVFP will need to be consistent with
investment return and inflation assumptions and will be based on the
shareholders required rate of return on the capital invested in the business
allowing for the inherent risks. The risk margin is added to the discount rate
for PVFP calculations.
A company may calculate a specific loss of investment return to calculate
the lock in of the solvency requirement.
Bonus rates
To calculate the present value of shareholder transfers there will need to be
assumptions regarding future bonus rates. These should be consistent with the
investment return assumptions used for with profits business. Allowance for
future bonus in the supervisory reserves may be very approximate.
Tax
The embedded value would need to allow for shareholder tax on profits, but
this would not be appropriate for the calculations of supervisory reserves.

Part (i) was a straightforward bookwork definition, where marks were generally lost for
not being precise in the answer and not referencing back to the shareholders. Part (ii)
was adequately answered and followed on from part (i), where candidates were expected
to explain how the present value of future profits attributable to shareholders, for each
product, and the shareholder owned net assets are determined. Most marks were lost for
not being specific enough to the question by discussing each of the unit-linked, without
profits and with profits products in turn. Part (iii) was poorly answered, most candidates
were too brief in their answers given the number of marks available. Some candidates
failed to consider the different assumptions in turn and when the answer was structured
in this way answers tended to be too vague or brief. It was not sufficient to just answer
prudent for each supervisory reserving assumption without giving an indication of what
prudent meant in each case.


Subject ST2 (Life Insurance Specialist Technical) September 2009 Examiners Report
Page 15
END OF EXAMINERS REPORT
Faculty of Actuaries Institute of Actuaries







EXAMINATION


22 April 2010 (pm)


Subject ST2 Life Insurance
Specialist Technical




Time allowed: Three hours

INSTRUCTIONS TO THE CANDIDATE

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

2. You have 15 minutes before 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 the
supervisor.

4. Mark allocations are shown in brackets.

5. Attempt all six 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 this
question paper.

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



Faculty of Actuaries
ST2 A2010 (J B 25.1.10 v7) Institute of Actuaries
SA2 A20102
1 A company sells conventional with profits policies. Bonuses are declared using the
additions to benefits simple bonus approach.

The company is considering changing to a compound or super-compound bonus
approach.

(i) Describe the simple, compound and super-compound approaches. [2]

(ii) Explain the advantage to the company of this change. [1]

Over the past three years the company has declared regular bonuses of 1% p.a. using
the simple approach. The actuary has determined that over the same period they
could have declared 0.5% three years ago, 1% two years ago and 1.5% last year using
the compound approach.

(iii) Determine the benefit amount for a single premium policy written three years
ago with a sum assured of 10,000, under both approaches. [2]
[Total 5]


2 A life insurance company is considering writing a new flexible unit-linked product
targeted at high net worth individuals. The product allows flexibility in the amount of
premiums payable and could be used either as a savings vehicle or to provide life
cover, or a mixture of the two. The policyholder can invest in a range of different unit
funds and switches can be made subject to charges. Annual fund management
charges vary by fund.

(i) Describe how the features of this product meet the needs of the target market.
[3]

(ii) Discuss the distribution channels that the company could use for this product.
[13]
[Total 16]


3 Describe the types of reinsurance that might be appropriate for the following:

(i) Without profits decreasing term assurance. [6]

(ii) Unit-linked endowment assurance. [2]

(iii) A life insurance company which has a low level of solvency. [7]
[Total 15]

ST2 A20103 PLEASE TURN OVER
4 (i) Describe dynamic solvency testing. [5]

A life insurance company has been established for many years and sells a wide range
of protection, savings and annuity products. The company has an investment
portfolio of 40% corporate bonds, 30% equities, 20% government bonds and 10%
cash.

The life insurance company has recently experienced the following:

a reduction in sales of 25% of the previous years level

worsening lapse experience on its unit-linked savings portfolio, with lapse rates
increasing from 6% p.a. to 10% p.a.; and

a fall in equity markets of 25% and a fall in corporate bond prices of 30%

(ii) Describe how these events are likely to have impacted the current solvency
position of the company. [10]

A director of the company has stated that he does not believe that the solvency
position of the company will deteriorate any further in the next few years as the
economic situation is bound to improve.

(iii) Discuss the investigations that should be undertaken in response to this
remark. [7]
[Total 22]


5 A life insurance company writes only regular premium unit-linked endowment
assurance contracts. The contracts provide a maturity benefit equal to the value of
units at maturity, and a death benefit equal to the greater of the value of units on death
and a guaranteed minimum monetary amount. The surrender value is the value of
units. A surrender penalty is applied if the surrender occurs within the first ten years
of the policy. Charges are deducted from the unit fund to cover expenses and the cost
of providing the life cover.

(i) State the principles that the company would consider when setting supervisory
reserves. [7]

(ii) Describe how the supervisory reserves may be calculated for these policies. [8]

(iii) Suggest possible inadequacies in the production of the reserves, other than
those related to methodology. [5]
[Total 20]

SA2 A20104
6 A whole life assurance policy with a sum assured of 10,000 is to be issued to a person
currently aged 60. The policy has an option such that at the fifth policy anniversary
the policyholder may take out a further whole life policy for a sum assured of 10,000,
at the companys standard premium rates and without evidence of health. Death
benefits are paid at the end of the year and the mortality basis used is assumed not to
change over time. Premiums are payable annually in advance.

(i) Calculate the additional premium that should be paid for the option over the
first five years of the contract, using the conventional method and assuming
the following basis:

Mortality: AM92 Select
Interest: 4% per annum
Expenses: None
Lapses: None
Tax: None [5]

An analysis of industry data has shown that the mortality experience of those who
take the option at age 65 is AM92 ULT plus 5 years added to the age, and the
assumptions for those who do not take the option is AM92 ULT less 1 year deducted
from the age. There is no data on the take up rates, but the company believes that the
aggregate mortality remains at AM92 ULT. The company also believes that
individuals make their decision whether to exercise the option based on their state of
health at the option date.

(ii) Calculate the additional premium that should be paid for the option, using the
North American method. [7]

(iii) Discuss the difference in the results between the conventional and North
American methods. [5]

(iv) Discuss how the company could manage the risk arising under the option. [5]
[Total 22]


END OF PAPER

Faculty of Actuaries Institute of Actuaries











EXAMINERS REPORT

April 2010 Examinations

Subject ST2 Life Insurance
Specialist Technical




Introduction

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


R D Muckart
Chairman of the Board of Examiners

J uly 2010




Comments

These are given in italics at the end of each question.









Faculty of Actuaries
Institute of Actuaries
Subject ST2 (Life Insurance Specialist Technical) April 2010 Examiners Report
Page 2
1 (i) Simple: Bonus expressed as a percentage of the basic benefit.

Compound: Bonus expressed as a percentage of the basic benefit plus any
attaching bonuses.

Super-compound: Bonus comprises two parts a bonus expressed as a
percentage of the basic benefit plus a bonus expressed as a percentage of the
attaching bonuses (bonuses previously declared). The bonus percentage
declared on bonuses is usually higher than the bonus percentage declared on
the basic benefit.

(ii) Defers distribution of profit which can improve capital efficiency. The super-
compound bonus method generally defers profit the most.

(iii) Simple Approach:

=10,000 +(1% * 10,000 * 3)

=10,300.00

Compound approach:

=10,000 * (1 +0.5%) * (1 +1%) * (1 +1.5%)

=10,302.76

This question was standard bookwork and was well answered by most candidates.


2 (i) The product allows flexibility in the premium payments which will allow the
investor to be able to alter premiums to suit their income. For example the
investor may receive irregular income or bonuses at certain times of the year
which he wishes to invest.

The product allows the investor freedom to invest in a variety of different
types of investment with the freedom to switch between types of investment.
This meets the needs of high net worth individuals who like the choice of
funds.

This will suit the financially sophisticated who want to be able to control their
investments, and change their investments as their appetite for risk changes.

It is also likely that the range of unit funds available will include some
relatively high risk funds, which would meet the needs of this type of investor.

The product is likely to be costly to run and so the charges are likely to be
high. This will be acceptable to investors who expect to pay more for a more
sophisticated product which is suited to their needs.

Subject ST2 (Life Insurance Specialist Technical) April 2010 Examiners Report
Page 3
The product may be used for other purposes e.g. potential use in inheritance
tax planning and ability to provide life assurance protection to family
members.

(ii) These are complicated contracts which will require careful explanation of the
benefits and charges at point of sale.

The product is aimed at high net worth individuals; it could be the case that
these potential customers may in fact even initiate a sale.

The company has the following options:

Insurance intermediaries

Insurance intermediaries (IFAs) are salespeople who must act independently
of any particular life insurance company.

Their aim is to find the best contract, in terms of benefits and premiums, for
their clients.

Usually they are remunerated, via commission payments, by the companies
whose products they sell, but they may alternatively receive a fee from their
clients.

It will often be the client who initiates the sale.

However, intermediaries are also likely to promote themselves actively to
existing clients by, for example, instigating a periodic review of finances.

This method of distribution would be a good choice for this contract since the
intermediary has access to the type of target market at which the product is
aimed and will have the expertise to ensure the customer understands the
contract and makes the correct decision.

As the IFA market is competitive the product will need to have terms
comparable with competitors.

Tied agents

Tied agents are salespeople who are tied to one, or sometimes several, life
insurance companies, that is they offer to their clients only the products of
those companies.

Typically they may be the employees of a bank or other similar financial
institution.

Where the tie is to more than one company, it will sometimes be the case that
the product ranges of the companies are mutually exclusive, but more often
there will be overlap.

Subject ST2 (Life Insurance Specialist Technical) April 2010 Examiners Report
Page 4
Tied agents are remunerated by the companies to which they are tied. The
remuneration could be in the form of commission payments or by salary plus
bonuses.

It will often be the client who will initiate the sale, but some tied agents may
actively engage in selling.

If the company already deals with tied agents then this method of distribution
would be a good choice so long as the clients of the tied agents fit the target
market.

Own salesforce

Members of the salesforce of a company will usually be employees of the life
insurance company and hence will only sell the products of that company.

They may be remunerated by commission or salary or a mixture of both.

It will usually be the salesperson who initiates a sale, making use of client
lists. However, once he or she has built up a rapport with a particular client, it
will then often be the latter who initiates further sales.

If the company employs its own salesforce then this is likely to be the logical
solution. However, the target market at which this contract is aimed is
unlikely to be on the existing client list as they are more likely to use a
distribution method that gives them access to a wider range of product
providers.

Training will need to be provided to the salesforce as this is a complicated
product.

Direct marketing

At present this takes four main forms:

mailshots
telephone selling
press advertising
internet selling

The instigator of the sale varies depending on the method used.

This is probably not a suitable method to use to distribute this product. Direct
marketing is normally limited to simple products; here the complex nature of
the contracts (the flexibility and charges) would require the product details to
be explained in person.

However it may be possible to generate initial interest in this product through
direct marketing in carefully selected media (e.g. high quality newspapers).

Subject ST2 (Life Insurance Specialist Technical) April 2010 Examiners Report
Page 5
This question was generally well answered although many candidates werent able to
elaborate or demonstrate a deeper level of knowledge to justify the answers they were giving.
For example, not stating why high net worth individuals may have variable income and so
flexibility over premium payment would be beneficial to them. In addition, many candidates
didnt state which sales method would be the most appropriate and which would be
inappropriate. Better candidates related the book work on sales channels to the question,
rather than just providing the standard list of features of each sales channel.


3 (i) Without profits decreasing term assurance

The product could be reinsured using original terms (also known as
coinsurance).

This method involves the sharing of all aspects of the original contract.

The ceding company may supply the reinsurer with the premium rates it is
using for the decreasing term assurance (DTA) it wishes to reinsure. In return
the reinsurer will determine the level of reinsurance commission it is prepared
to pay the company.

Alternatively, the reinsurer may provide reinsurance rates to the ceding
company on which it can load for profit and costs.

There are two ways of specifying the amount to be reinsured, quota share and
individual surplus.

Under quota share a fixed proportion of each policy is reinsured, so for DTA
the amount reinsured on a policy reduces over the term of the contract.

For individual surplus the amount reinsured is the excess of the benefit over
the ceding companys retention limit on an individual life.

It will depend on the exact terms of the treaty in place, but for DTA this may
mean that smaller policy sizes will not be reinsured if the retention limit is
above the sum assured selected by the policyholder and that as the sum
assured reduces over time the policy may no longer remain reinsured.

Another method of reinsurance that could be used would be to use risk
premium reinsurance.

Risk premium reinsurance is where the ceding company reinsures part of the
DTA sum assured with the reinsurer on the reinsurers premium basis.

The risk premium rates may be guaranteed or reviewable.

As with original terms the amount reinsured may be determined on a quota
share or individual surplus basis.

Subject ST2 (Life Insurance Specialist Technical) April 2010 Examiners Report
Page 6
(ii) Unit-linked endowment assurance

A company is unlikely to be able to gain reinsurance for the unit liability as
the reinsurer would need to match the unit liability.

Reinsurance could be obtained to protect a company against the mortality risk
that would exist from the guaranteed sum assured under the product.

Risk premium reinsurance is most likely to be used.

The amount reinsured can be on a quota share basis or an individual surplus
basis.

(iii) An insurance company which has a low level of solvency

The company may use financial reinsurance to quickly improve its low level
of solvency.

There are two primary types of financial reinsurance that can be used, asset
enhancing and liability reduction.

For asset enhancing, the reinsurer gives the company funds, with repayment
contingent on the future emergence of the pricing and reserving margin, in the
form of cash, over a given number of years.

This increases the assets in the regulatory balance sheet, but has no impact on
the amount of liabilities as repayment is contingent on the future emergence of
the margins.

There will be little to no change in the realistic accounts.

Liability reduction is often known as virtual capital or time-deferred-stop-loss.

The reinsurer agrees to cover a set amount of claims relating to policies of the
longest term within the reinsured block of business.

The company can then reduce its liabilities by the set amount and assets are
marginally reduced, by the reinsurance fee.

As the future margins emerge as cashflows over time the company recaptures
the risk.

Company X may also use other types of reinsurance (if it is not already) to
increase its solvency level in the longer term. This would help to reduce total
claim payouts, claim fluctuations and reduce new business strain.

A company with low solvency would need to take particular care over its
choice of reinsurer to minimise counterparty risk.

Subject ST2 (Life Insurance Specialist Technical) April 2010 Examiners Report
Page 7
This question was relatively poorly answered despite being a bookwork type question. The
better candidates recognised which types of reinsurance were appropriate, and gave valid
reasons. These candidates scored better than those who purely listed all types of reinsurance,
whether relevant or not, and did not consider the type of business in the questions. For
example, better candidates recognised that a reinsurer could not cover the unit liability of
unit-linked business.


4 (i) Dynamic solvency testing is the assessment of a life insurance companys
future solvency position under a range of different economic and company
specific circumstances.

It involves projecting the life insurers balance sheet and revenue account
forward for a number of years and looking at the insurers solvency position in
each of those years.

The projection needs to be for a sufficient period of years that the full effect of
any potential risks may become apparent.

In particular, the life insurance companys ability to withstand future changes
(in both the external economic environment and the particular experience of
the company) would be investigated.

The projections could be done deterministically by stressing the relevant
assumptions to test the effect of adverse future experience or the projections
could be carried out using stochastic assumptions, with simulation to assess
the level of probability of such adverse circumstances occurring (i.e. the
probability of ruin).

When carrying out dynamic solvency testing consideration has to be given as
to whether to allow for new business or not in the projections.

Assuming that the insurer is open to new business then allowing for new
business is likely to give a more realistic assessment of the companys ability
to withstand future adverse events.

Analysis of the impact of new business would influence the companys new
business strategy and future development plans.

(ii) In terms of solvency position, assume that we are looking at the impact on the
companys statutory free assets, i.e. on the statutory valuation basis including
any solvency capital.

Considering first of all how each of the events is likely to have impacted the
current solvency position of the company:

A reduction in sales of 25% of the previous years levels:

When written, new business normally causes capital strain due to high
acquisition expenses and initial reserving and solvency capital requirements.
Subject ST2 (Life Insurance Specialist Technical) April 2010 Examiners Report
Page 8
The fall in new business will therefore reduce this new business strain.

However, the company may have experienced a change in the mix of business,
e.g. a recession may lead to fewer policyholders taking out discretionary
savings products. Hence whether the new business strain has actually fallen
this year compared to the previous year will depend on the mix of business
written.

The reduction in sales is likely to increase the per policy expenses on the
remaining business as costs are spread over a smaller book. This could
contribute to a worsening solvency position.

Worsening lapse experience on its unit-linked savings portfolio:

It is not clear to what extent the company has to hold statutory non-unit
reserves and solvency capital for these unit-linked savings contracts. This will
depend on the local regulations depending on which country the life insurance
company operates in.

The worsening lapse experience will result in higher statutory reserves and
solvency capital being released than expected if the surrender values paid are
less than the total of unit reserve, non-unit reserve and solvency capital.

In addition there may be a knock-on impact that, due to the higher lapses, the
per policy expenses on the remaining business may increase, which could
contribute to a worsening solvency position.

A fall in equity markets of 25% and in corporate bond prices of 30%:

We are told that the company is invested 40% in corporate bonds and 30% in
equities and assuming that the company is widely diversified and hence
experiences the same losses as the overall market, then the market value of the
companys assets has fallen by [(40% 0.3) +(30% 0.25) =12% +7.5% =
approx. 19.5% (ignoring any change in value of the government bonds).

Unit reserves will reduce but this will be offset by a reduction in backing
assets.

The statutory reserves may be valued using the yields derived from the
underlying portfolio of assets held.

The fall in corporate bond prices means that the yield on corporate bonds has
increased, as has the dividend yield on equities.

The rise in corporate bond yields will result in a rise in the valuation interest
rate which will reduce the liabilities.

Whilst the valuation interest rate may increase, due to the increased yields on
the equity and corporate bond assets, it is unlikely to increase to the same
extent as the actually increase in the yields.
Subject ST2 (Life Insurance Specialist Technical) April 2010 Examiners Report
Page 9
Hence the statutory value of the liabilities may fall, but not by as much as the
fall in the value of the assets.

The relative impact also depends on the degree to which statutory liabilities
and assets are matched by term.

If the solvency capital is defined as a % of statutory reserves, solvency capital
may also fall.

The future fee income expected on the unit-linked savings business will have
fallen dramatically as a result of the fall in the equity and corporate bond
markets.

If this future fee income is allowed for in the calculation of the non-unit
reserves then the drop in expected future fee income (due to the lower unit
fund values) is likely to lead to an increase in the non-unit reserves (or a
reduction in negative non-unit reserves).

The cost of guarantees is also likely to have increased as a result of the falls in
asset values.

It seems likely that overall, the fall in equity markets and corporate bond
markets, is likely to have significantly worsened the overall solvency position
of the company.

General comments

Whilst it is not possible to know for sure the overall impact on the solvency
position of the life insurer, the fall in the asset markets seems most likely to be
the event that drives the overall impact on the company.

Although this impact may be mitigated to some extent by actions taken by the
management.

The first two events impact the level of one years worth of new business
(which is likely to be a small impact in relation to the size of the in-force book
for a well established insurer) and the level of lapses on one part of the
product portfolio.

It should be recognised that lower sales does not automatically mean that the
companys solvency position will have improved. This depends on the
balance between the level of new business strain and the surpluses being
released from existing business, and the extent that any new business strain is
mitigated by reinsurance financing.

But overall it seems likely that the solvency position of the company will have
worsened as a result of the combination of the three events mentioned.

(iii) Although it is possible that the situation will improve, this is not guaranteed
and there may be future deterioration in experience.
Subject ST2 (Life Insurance Specialist Technical) April 2010 Examiners Report
Page 10
The life insurer has a responsibility to ensure that it remains solvent in all
possible foreseeable events.

And the local regulator is likely to also want the company to be able to
demonstrate that it will remain solvent in all possible foreseeable events.

Dynamic solvency testing is particularly useful in this context, especially
where stochastic simulations are used, with probability weights attached to
each stochastic projection, since this will provide the insurer with insight into
the future solvency position of the company in a range of what if scenarios.

Hence the insurer can investigate what would happen to the projected
solvency position of the company in a range of economic scenarios. This
would include a wide variety of scenarios such as:

A scenario similar to the one that the marketing director anticipates, where
equity and corporate bond prices revive, sales volumes return to more
normal levels and lapses return to the long term assumed levels. Whilst
interesting, this is likely to be the best case scenario.

A scenario where conditions continue to worsen where one or more of the
following scenarios are included sales volumes continue to deteriorate,
continued change in mix of business, continued deterioration in
persistency or further falls in stock markets

A number of different versions of this scenario are likely to be tested e.g.
specific shock events (1 day fall in stock market of further 20%),
long term steady deterioration etc.

The recent events might have resulted in the company changing its views of
constitutes a reasonable adverse scenario, particularly if the actual events
were worse than those previously anticipated.

If the company does its dynamic solvency testing stochastically then it will
have to recalibrate its economic assumptions to the current conditions, which
may for example have higher volatility than previously.

The insurer will project the balance sheet and the income statement for a
number of years under each of these economic scenarios. The company will be
able to analyse the impact on its solvency position in each future time period.

The insurer may explore the impact of each event separately initially, and then
combinations of events, to better understand the knock on possible impact of a
number of events occurring at the same time.

The insurer will be able to explore how it could improve its solvency position
in certain events by considering the management actions that it could take in
response to certain events e.g. reducing bonuses/crediting rates, increasing
mortality charges, increasing AMCs/policy fees etc.

Subject ST2 (Life Insurance Specialist Technical) April 2010 Examiners Report
Page 11
In extremely negative scenarios, the insurer may want to consider the impact
of more strategic events, such as closing particular lines of business or
distribution channels, changing the business mix significantly, introducing
new low-cost distribution channels, stopping sales in particular geographic
regions etc.

The investigations should be updated frequently (especially during times of
uncertainty), such that the Board of Directors can use the information to
monitor the solvency position of the company.

Investigations should be made into the reasons behind the movements and
potential impacts on expectations of the future. This could include seeking
expert external opinions.

This question was poorly answered. Part (i) was bookwork but many candidates missed out
on basic points. In part (ii) the better candidates discussed the impact of reduced sales on
both NB strain and future expenses. For increases in lapses they recognised that the company
would have been holding a reserve; poorer candidates did not consider this and purely
considered the outgo from the surrender. For the market fall part of the question a number
of candidates failed to consider the impact on both assets and liabilities. Better candidates
also included comments on the level of matching and the impact on non-unit reserves. Part
(iii) was poorly answered by many candidates and only the exceptional candidates
recognised the need to use dynamic solvency testing, despite it being the subject of the first
two parts of the question.


5 (i) The reserves should be sufficient to meet all liabilities arising out of the
contract.

The reserves should be calculated by a suitably prudent actuarial approach.

The reserve should be at least as great as the guaranteed surrender value (i.e.
the face value of units).

Non-unit reserves should be held.

The reserves should cover future expenses, including commission.

The reserves should take credit for premiums due to be paid under the terms of
each policy.

A prudent valuation is not a best estimate valuation and should include
appropriate margin for adverse deviation of the relevant factors.

Valuation should take account of nature, term and method of valuation of
corresponding assets.

Use of appropriate approximations and generalisations is allowed.

Subject ST2 (Life Insurance Specialist Technical) April 2010 Examiners Report
Page 12
Valuation rate of interest for the non-unit reserve should be chosen prudently
taking into account currency of policy and having regards for yields on
corresponding existing assets and yield expected to be obtained on sums
invested in the future.

Demographic and persistency assumptions should have regard to type of
business and country of residence.

Method should recognise profit in an appropriate way.

The method should not be subject to discontinuities arising from arbitrary
changes to the valuation basis.

Method and bases should be disclosed.

(ii) The reserve will comprise two components: a unit reserve and non-unit
reserve.

Unit reserve equal to the value of units held at the valuation date.

As the contract has surrender penalties the company could use actuarial
funding to hold reserves less than unit value.

Consider year-by-year (or month-by-month) occurrence of non-unit related
cashflows.

Project forward unit reserves including allowance for allocated premiums,
fund charges, investment return etc

Project forward non-unit cashflows on reserving basis allowing for the
following items:

charges received (AMCs, policy fees)
bid/offer spread
expenses expected to be incurred in the future
commission expected to be paid
mortality charges received
expected death claims in excess of the unit fund
surrender penalties

Perform projections on a policy-by-policy basis and start with last projection
period in which net cash flow becomes negative.

Amount set up at start of this period sufficient to zeroise negative cashflows,
after allowing for earned investment return over the period.

This amount is then deducted from the net cash flow at the end of the previous
time period.

Subject ST2 (Life Insurance Specialist Technical) April 2010 Examiners Report
Page 13
The process continues to work backwards towards valuation date with each
negative being zeroised.

If adjusted cash flow at the valuation date is negative then a non-unit reserve is
set up equal to this absolute amount.

As there are surrender penalties it may be permissible to hold negative non-
unit reserves, subject to certain other conditions being met. For example, total
reserve should be greater than or equal to the surrender value.

Ensure that the relevant reporting regulations of the local country are met and
hold a mismatch reserve if required.

(iii) Data

May be valuing cancelled policies in error.

May be missing some policies.

Inadequate/incomplete policy data e.g. premiums, maturity date, age etc.

Data errors (e.g. decimal point in wrong place when input).

Unit reserve incorrect due to unit pricing error.

Reinsured business incorrectly allowed for (e.g. incorrectly marked as
reinsured or the treatment of the reinsurance in the valuation does not reflect
the actual treaty).

Using rolled forward rather than actual data, due to reporting deadline
pressures.

Assumptions

Valuation basis not prudent enough or may be excessively prudent.

Demographic assumptions may not reflect latest expected future experience of
business.

Valuation interest rate may not reflect assets backing the business.

Assumptions may not allow for known future changes e.g. expenses.

Surrender assumptions may not reflect impact of surrender penalties.

Other

Potential calculation errors in any manual reserves or using inappropriate
approximations.

Subject ST2 (Life Insurance Specialist Technical) April 2010 Examiners Report
Page 14
Errors in automated valuation systems, e.g. due to lack of testing.

Basis may not be documented adequately.
Not keeping up with guidance/regulatory changes.

Model not including all relevant product features.

Part( i) was bookwork which was generally well answered although key items of the
bookwork were missed by many candidates. In part (ii) candidates who could logically
describe how a non-unit reserve was calculated scored well, although many candidates failed
to mention that a unit reserve needed to be calculated and projected. Part (iii) was poorly
answered, many candidates focused on one area rather than thinking widely. For example,
considering many types of problems with assumptions but not considering issues with data or
models.


6 (i) Using the conventional method, the information we require is:

A
[60]
=0.45510
A
65
=0.52786

[60]
=14.167

65
=12.276
D
[60]
=880.56
D
65
=689.23

[60]:5
=4.559
A
[65]
=0.52550

[65]
=12.337

The expected present value of the benefit is:

EPV(B) =10,000*(A
[60]
+D
65
/D
[60]
*A
65
)

=10,000*(0.45510+689.23/880.56*0.52786) =8682.7

The expected value of premium income is:

EPV(P) =P(A
[60]
)
[60]
+P(A
[65]
)* D
65
/D
[60]
*
65


P(A
[60]
) =10,000*A
[60]
/
[60]
=10,000*0.45510/14.167 =321.24

P(A
[65]
) =10,000*A
[65]
/
[65]
=10,000*0.52550/12.337 =425.95

321.24*14.167 +425.95*689.23/880.56*12.276 =8643.8

So the expected present value of the option is 8682.7 8643.8 =38.90

Credit was given if candidates approached this part by taking the value of the difference in
the theoretical premium less actual i.e. P(A65) = 430 and so:
(430 425.95)*12.276*689.23/880.56 = 38.915

Subject ST2 (Life Insurance Specialist Technical) April 2010 Examiners Report
Page 15
This must equal the expected present value of the extra premium to cover the
option cost, so:

P(extra) [60]:5 =38.90 (or 38.81 if used unrounded numbers)
P(extra) =38.90/4.559 =8.53 (or 8.51 if used unrounded numbers)

Where candidates used different methods, appropriate credit was given provided full
workings were shown.

(ii) One way of determining the take up rate is to calculate the rate required such
that the ultimate mortality at age 65 can be derived from the assumed rates for
healthy and unhealthy lives.

The ultimate mortality rate at 65 =0.014243
The rate of those who take the option 65 +5 =0.024783
The rate of those who do not take the option 65 1 =0.012716

Assuming 100% of those who would benefit from the option will take the
option, we can equate the percentage (x) that take the option from the
following equation:

x * 0.024783 +(1 x) * 0.012716 =0.014243

so x =0.12654

Other methods were given credit provided full workings and assumptions were shown.

Using the North American method:

The expected present value of the cost of providing the option is the expected
present value of the benefits less the expected present value of the premiums.

The additional information we need is:

A'
65
=A
70
=0.60097

'
65
=
70
=10.375

The expected present value of the benefits is:

EPV(B) =10,000*(A
[60]
+0.1265* D
65
/D
[60]
*A'
65
)

EPV(B) =10,000*(0.45510 +0.12654 * 689.23/880.56 * 0.60097) =5146.0

Subject ST2 (Life Insurance Specialist Technical) April 2010 Examiners Report
Page 16
The expected present value of the premiums (excluding the extra premium) is:

EPV(P) =321.24 *
[60]
+D
65
/D
[60]
*0.1265* '
65
* 425.95

=321.24*14.167+689.23/880.56*0.12654 *10.375*425.95 =4988.7
The expected present value of the additional cost of the option is therefore:
5,146.2 4,988.7 =157.5

Credit was also given where the value of the premiums saved was calculated instead, i.e.
10,000*A
70
/
70
= 10,000*0.60097/10.375 = 579.25
0.12654 * (579.25 425.95)*10.375 * 689.23/880.56 = 157.53

P(extra) *
[60]:5
=157.5

P(extra) =157.5/4.559 =34.55

Credit was also given if candidates followed the approach of disaggregating the contract
fully from year 5 then give relevant marks for the workings. The answer would be different
but valid:

EPV(B) = 10,000*(0.45510 689.23/880.56*0.52786)
+ (0.1265*20000*.60097 + (1 0.1265)*0.51333*10000)
* 689.23/880.56 = 5119.1

EPV(P) = 321.24*(4.559 + 689.3/880.56*(10.375*0.1265
+ (1 .12654)*12.653)) + 425.95*689.3/880.56*.1265*10.375
= 5011.3

So option = 107.8

Note it is important that the candidate recognised that the total mortality post year 5 is
ultimate and does not assume that those not taken the option are ultimate on their own.

(iii) The North American method gives a significantly higher cost than the
conventional method.

There will be an impact for the fact that the assumed take up rate is based on
the q at age 65 whereas the costs include valuing benefits using mortality for
the rest of life, and the proportion with higher mortality would not remain at
this fixed level. However this is unlikely to be the main reason.

The key reasons that the cost for the conventional method is lower is because
there is the assumption that 100% of policyholders take the option and the
assumed mortality is different. Those with healthier lives have mortality rates
which are lower than those assumed in the new policy pricing basis, even
allowing for the selection allowance in the pricing.

These policyholders are paying more than the cost of their benefits and so are
subsidising the policyholders in ill health.

Subject ST2 (Life Insurance Specialist Technical) April 2010 Examiners Report
Page 17
It is unlikely that these policyholders could get special rates on the market due
to them having slightly lower mortality than the select rates imply, and so they
may well take the option.

However, since they could get standard rates based on select mortality in any
case, it is optimistic to assume that 100% would take the option.

Therefore the cost based on the conventional method is likely to be too low.

(iv) The insurer should adopt continual monitoring and review of the benefits of
options versus their costs.

At an objective level, the insurer should seek to monitor the charges/loadings
included for options in the product pricing with the actual costs being
experienced.

The analysis should look separately at both the uptake rate for the option and
the profit or loss which arises once an option is exercised.

Mortality experience analyses should be performed looking at those who take
the options and those who dont as well as looking at the combined
experience.

If these assessments show that the continued availability of the option, even
allowing for a subjective assessment of the increased marketability which the
option brings, carries a net loss for the insurer then the options pricing should
be increased and/or its availability should be reduced or removed altogether.

The time lag between removal of an option and the impact on experience
emerging must be borne in mind. It is easier, legally, to amend suitably the
terms of new business written.

It may also be possible to reduce the impact of options under existing business
by a strict interpretation of policy literature, subject always to the
interpretation satisfying policyholders reasonable expectations.

The company could also ensure that initial underwriting is appropriately strict,
taking into account the potential future option.

The company may use reinsurance to manage the overall risk, although the
reinsurer will include charges to reflect the uncertainty regarding the option.

The company could add margins in both the pricing of the option and the
valuation bases until adequate data is determined.

The answers to this question were very mixed. Candidates generally answered part (i) well
but struggled with the other parts. Marks were awarded for all valid approaches. Many
students lost marks for looking up incorrect values from the actuarial tables, however follow
through marks were awarded if this was the only mistake. In part (ii) many candidates lost
marks for using a too simplified approach for the take-up assumption. Parts (iii) and (iv)
Subject ST2 (Life Insurance Specialist Technical) April 2010 Examiners Report
Page 18
were poorly answered. Many candidates in part (iii) purely stated the difference between the
two approaches but did not expand wider to consider points such as healthy policyholders
cross-subsidising those in ill-health. In part (iv) most candidates mentioned reinsurance and
underwriting but only the better candidates considered performing experience analyses for
take-up and mortality, and reviewing the rates following such reviews.


END OF EXAMINERS REPORT
Faculty of Actuaries Institute of Actuaries







EXAMINATION


4 October 2010 (pm)


Subject ST2 Life Insurance
Specialist Technical



Time allowed: Three hours

INSTRUCTIONS TO THE CANDIDATE

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

2. You have 15 minutes before 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 the
supervisor.

4. Mark allocations are shown in brackets.

5. Attempt all six 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 this
question paper.

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



Faculty of Actuaries
ST2 S2010 Institute of Actuaries
ST2 S20102
1 A life insurance company operates a number of internal unit-linked funds. Unit prices
are calculated daily. All the funds are expanding, and therefore are priced on an offer
basis.

(i) Explain the basic equity principle as it applies to the pricing of an internal
unit-linked fund. [3]

(ii) Describe how this principle is applied when determining the appropriation and
expropriation prices for a fund. [3]

The following details are for the Equity Fund as at the end of 31 March 2010.

Market value of assets (excluding cash) within the fund =50,000
Cash balance in the fund =750
Number of units =10,000
Selling costs of assets in the fund =1,376
Purchasing costs of assets in the fund =1,152

The market value and cash balances allow for current assets and liabilities of the fund,
and any accrued income or tax adjustments.

There is an initial charge of 3% and all offer and bid prices are rounded to three
decimal places.

Prices are calculated at the end of 31 March 2010, and applied to new requests for
investments or disinvestments received during that day.

(iii) Calculate the following in relation to this fund, stating any assumptions:

(a) Appropriation Price

(b) Expropriation Price

(c) Offer Price

(d) Bid Price

(e) Number of units purchased by a new investment of 1,500 received on
31 March 2010
[6]
[Total 12]


ST2 S20103 PLEASE TURN OVER
2 A life insurance company has recently started selling a regular premium unit-linked
endowment assurance product. The death benefit is the maximum of the total
premiums payable over the lifetime of the policy and the bid value of units. This
benefit is charged for by a monthly deduction of units based on the sum at risk each
month.

In the past a similar contract was offered, with the exception that the death benefit
was the bid value of units. It is proposed that policyholders with this older version
should be offered the opportunity to add the same minimum life cover to their policy
as is provided under the new version of the product.

Discuss the factors that the company would need to consider before adopting this
proposal. [9]


3 A life insurance company has written unit-linked single premium bonds for a number
of years.

The company is expanding into the unitised with profits bond market. Regular
bonuses would be added annually and may be zero but never negative.

(i) Describe the alternative approaches for applying the regular bonuses to the
unitised with profits bond. [4]

(ii) Discuss the product features and assumptions which the company would need
to consider for the launch of the new bond. [10]
[Total 14]


4 A life insurance company has sold a wide range of life insurance products through
independent intermediaries for many years. A proposed change in legislation means
that it will no longer be attractive to sell solely through this channel. The life
insurance company is considering setting up a direct sales force.

Discuss the issues that the company should consider in setting up a direct sales force.
[15]


5 A life insurance company sells non-reviewable conventional without profits term
assurances and individual unit-linked endowment assurances.

(i) Outline the features of these products. [8]

(ii) Describe the main risks to the policyholder of purchasing each of these
products. [6]

(iii) Discuss the risks to the life insurance company of selling these products. [14]
[Total 28]



ST2 S20104
6 A life insurance company sells conventional with profits endowment assurance
policies. It has 15,000 of these policies in-force at the very start of the year and sells a
further 2,000 new policies on the first day of the year. The features of the business
are as follows:

Cohort Number
of
policies
Average
individual
asset
share at
the start
of the
year

Average per
policy sum
assured plus
attaching
reversionary
bonus
Average
per policy
terminal
bonus
payable on
death
Expected
death
rates
based on
100%
mortality
table X
Average
premium
per
policy
(annually
in
advance)
Number of
deaths
occurring
at the end
of the year

A 10,000 $5,000 $5,000 $1,000 0.020 $600 150
B 5,000 $4,000 $4,500 $1,000 0.010 $600 60
C (New
business)
2,000 $0 $3,500 $500 0.007 $700 5

All premiums are received on the first day of the year.

During the year the investment income (net of investment expenses) on the assets
backing the asset shares totalled $4.3 million.

Total acquisition expenses incurred in the year were $1.5 million.

Total maintenance expenses were $510,000 payable annually in advance and
allocated to both in-force and new business.

Commission is 2% of every premium.

Deaths occur at the end of the year but before the declaration of any regular bonuses.
There were no surrenders or maturities during the year. The company pays no tax.

The company pays shareholder transfers at the end of the year of one ninth of any
terminal bonuses paid during the year plus one ninth of the cost of the declared
bonuses added to policies in-force at the end of the year (after any deaths that occur).
The company declared a regular reversionary bonus at the year end at a rate such that
the cost, before any shareholder transfers, was 4% of the existing sum assured plus
attaching reversionary bonus.

(i) Calculate the total aggregate asset shares at the year end for the whole
portfolio, explaining your approach. [5]

ST2 S20105
The company calculates individual policy asset shares using actual death rates applied
to the asset shares, where the death rates are taken from mortality table X and
multiplied by a factor F. The factor F is based on total actual deaths divided by total
expected deaths assuming 100% of mortality table X.

(ii) Show that factor F is equal to 0.81439. [2]

(iii) Calculate the individual asset share for an average policy within cohorts A and
C, explaining your approach. [8]

The individual asset share for an average policy within cohort B is $4,782.

(iv) Discuss the difference between the aggregate asset shares and the sum of the
individual asset shares. [7]
[Total 22]


END OF PAPER
INSTITUTE AND FACULTY OF ACTUARIES









EXAMINERS REPORT

September 2010 examinations

Subject ST2 Life Insurance
Specialist Technical




Introduction

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


T J Birse
Chairman of the Board of Examiners

J anuary 2010











Institute and Faculty of Actuaries
Subject ST2 (Life Insurance Specialist Technical) September 2010 Examiners Report
Page 2
1 (i) Basic Equity Principle

For unit holders the only prices relevant are those at which they buy units in
the fund and those at which they redeem their units.

In theory, the movement in price between those two events should only reflect
the performance of the assets backing the unit and charges deductible under
the policy provisions.

Price should not be affected by creation or cancellation of other units,
otherwise cross subsidies between unit holders will arise.

The basic equity principle of unit pricing for an internal fund is therefore that
the interests of unit holders not involved in a unit transaction should be
unaffected by that transaction.

(ii) The basic equity principle is only achievable if the amount of money put into
the fund, or taken out of the fund, is such that the net asset value per unit is the
same before or after appropriation.

Appropriation price is this amount of money when creating a unit. It preserves
the interests of existing policyholders.

Expropriation price is this amount of money when cancelling a unit. It
preserves the interests of continuing policyholders.

(iii) (a) Appropriation Price

MV of assets (excluding cash) 50,000.00
Cash Balance 750.00
50,750.00

Total fund value =Market value of assets +purchasing costs of assets
=50,750 +1,152 =51,902
Number of units =10,000
Appropriation Price =5.1902 per unit

(b) Expropriation Price

Deduct sales costs from appropriation price total fund value

Fund value =50,750 1,376 =49,374
Expropriation Price =4.9374 per unit

Subject ST2 (Life Insurance Specialist Technical) September 2010 Examiners Report
Page 3
(c) Offer price

Assumes continuing on an offer basis
Offer price =appropriation price plus initial charge
Initial charge of 3%
Offer Price =5.1902 / 0.97 =5.350722
Rounded to 3dps =5.351

(d) Bid Price

On offer basis, bid price =appropriation price
Rounded to 3dp
Bid Price =5.190

(e) Units purchased by 1,500

Offer price used for purchases
1,500 / 5.351 =280.321 units

Part (i) candidates were able to state the basic equity principle but given the number of
marks available few expanded upon this. In part (ii), a common mistake was to provide a
description of the appropriation and expropriation prices and how they are calculated rather
than answering the question and relating that back to the basic equity principle. Part (iii)
was well answered although some candidates were confused as to how the selling and
purchasing costs affect the appropriation and expropriation prices.


2 The proposal impacts existing business only, so the motivation needs to be
understood. It may have been proposed in order to reduce lapses, either to the new
product or to competitors.

Under the original policy, the only mortality risk to the company was that initial
expenses may not have been recouped on early death.

The product design would not have encouraged any anti-selection with regard to
mortality.

As a result, it is highly unlikely that any underwriting would have been carried out at
the point of sale.

For the new product, the additional life cover is an integral part of the product, which
is largely used as a savings vehicle, and so there is likely to be little anti-selection
from new policyholders.

For the policyholders with the old version, it is likely to be the less healthy that take
up the offer. Alternatively the demographics of the policyholders with the old version
of the product may be different to the new version.

If the company intends to charge a different (i.e. higher) base level of mortality
deductions than those under the new version, to allow for any anti-selection risk or
Subject ST2 (Life Insurance Specialist Technical) September 2010 Examiners Report
Page 4
differences in demographics, then it needs to consider any potential adverse impact
arising from this, such as reputational damage.

Underwriting should also be carried out where the potential sum at risk is high.

In assessing this, the company should consider potential falls in unit values.

The company needs to consider how the cost of underwriting would be recouped.

The company should accept that there are likely to be a higher level of rated and
rejected cases.

This may cause brand damage having written and offered the option to those
policyholders.

The mortality deductions from the fund will lead to lower maturity values compared
to before. Or the premiums could be increased to target a similar maturity value.

In the latter case, it would alter the minimum sum assured.

Clear communications (including projections) to policyholders will be required to
inform policyholders of the changes in potential maturity value or the level of
premium.

The company would need to consider whether the reduction in fund will lead to
reduced charges for the company (e.g. reduced annual management charges.), which
could lead to reduced profit or non-recovery of expenses or whether the mortality
charges include a profit loading that would mitigate this.

If the company does not offer the option then there is a lapse and re-entry risk.

The most benefit from the option would be early in the policy term when the fund
value is low.

However, surrendering at this time would possibly incur surrender penalties.

Ease of administering the proposal is important. For example, if the two products are
administered on the same system it may be relatively simple.

If the development cost was significant, it is unlikely to be in the companys interest
to make this offer. Also if the take up rate for the option due to lack of perceived
benefit to the policyholder is expected to be low, resulting in low volumes, then the
development costs my not be recouped.

Impacts on reserving levels and capital requirements would need to be taken into
account.

An analysis of the potential overall impact on profits would be required.

Subject ST2 (Life Insurance Specialist Technical) September 2010 Examiners Report
Page 5
The sensitivity of profit may also be investigated as would any changes in the risk
profile.

There may be regulatory requirements to take into account when amending a policy
(e.g. ensuring that the charges and underwriting proposals treat customers fairly).

If the likely overall sum at risk on the converted business is high then the company
might want to consider reinsurance, and so the proposal would have to be discussed
with reinsurers.

This question was generally poorly answered, many candidates did not properly understand
the guarantee being applied to the contract and did not discuss the additional charges that
the company would take and the impact that they would have on the expected maturity value


3 (i) Additional units approach
The unit price remains constant. The company allocates additional units to
each contract at the bonus declaration date, this could be using a compound or
super-compound approach. The number of bonus units is determined at the
discretion of the company. Bonus units added may be zero but units will not
be taken away.

Unit price approach
No additional units are allocated. The price of a unit changes to reflect the
bonus addition. The level of the movement in the unit price is at the discretion
of the company. The change may be zero but will not be negative.

(ii) Product Features
The company needs to consider whether the UWP contract is to be offered as a
stand alone product, or as an option within the existing unit-linked bond.

The company needs to consider how regular bonuses will be added to the
policy, either through addition to units or by changing the unit price and on the
split between reversionary and terminal bonus.

A scale of surrender penalties will need to be determined, and the company
may decide to use the existing scale for the unit linked bond and amend if
appropriate.

The company must decide whether any terminal bonus should be included on
surrender and if so, from which point in the term of the policy.

The company is likely to introduce the right to apply Market Value Reductions
(MVRs) to the face value of units.

The size of the MVR will be at the discretion of the company.

The company might consider offering one or more no-MVR guarantee
dates, e.g. on the tenth policy anniversary.

Subject ST2 (Life Insurance Specialist Technical) September 2010 Examiners Report
Page 6
The death benefit should be defined, e.g. return of fund value.

The company might guarantee that no MVR will be applied on death.

The company will need to decide if the death benefit should include any extra
element of terminal bonus.

If no terminal bonus is paid on death and/or surrender then the company
would need to consider how it ensures that policyholders are treated fairly
regarding the regular bonus allocation.

Charges could remain in current format as those applied to the unit-linked
version of the bond, or the company could take charges implicitly through
bonus rates.

The company may need to review level of charges if any experience
assumptions have changed.

The company would need to consider how to treat increments/top ups.

The company would need to consider whether it was going to alter the
maximum and minimum limits, for example on premiums, ages or terms.

When considering the product features to offer the company would also need
to consider the product features offered by its competitors.

The product feature may be restricted by the ability to incorporate them on the
companys administration system.

Assumptions
Investment growth assumptions will differ from the unit-linked version as it
will depend on the mix of with profits assets chosen.

A stochastic investment model is required if any no-MVR guarantee dates
are given.

Lapse rates will need to be reviewed.

The bond is likely to appeal to a different target market so different experience
may be expected.

The company will need to allow for the impact that the change in surrender
penalties will have on lapse rates.

The company also has to consider selective lapses if a no-MVR guarantee
date is given.

Expenses may differ from the unit-linked version of the contract.

Subject ST2 (Life Insurance Specialist Technical) September 2010 Examiners Report
Page 7
The ability of the charges to recover development expenses would also need to
be considered.

The company would need to reconsider its assumptions regarding the level of
new business volumes and new business mix to review the recoverability of
expenses.

The company may need to review the expense inflation assumption too.

The company needs to decide what level of commission to pay.

Mortality is unlikely to be materially changed from the unit-linked version.

The company would need to reconsider its assumptions regarding the level of
new business volumes and new business mix to review the recoverability of
expenses.

Part (i) was reasonably well answered. In part (ii), answers tended to be generic rather than
focusing on the specific product features of a unitised with-profits product. Better candidates
were able to demonstrate an understanding of the contract and describe the product features
well such as death and surrender benefits and details regarding how an MVR might be
applied.


4 General information on existing DSFs

First of all the insurer will consider whether DSFs are already common in the market
place and the portion of total sales of life policies sold through DSFs compared to
other channels by their competitors.

If DSFs are already quite common and well established, analysis will be carried out
on the competitors sales forces, such as collecting details about the size of the sales
forces, the branch networks/coverage of each geographical area, and the level of sales
achieved by those sales forces.

The insurer may be able to get statistics from an industry body relating to the
productivity of direct sales forces in the market.

The company would also want to decide upon the size of the direct sales force
required.

Consider how other companies, who currently only sell through independent
intermediaries, will react and the impact this will have on companys ability to
develop a direct sales force.

Costs

In order to understand the costs of having a DSF, the life insurer will need to consider
both the initial development costs and those that will be incurred on an ongoing basis.

Subject ST2 (Life Insurance Specialist Technical) September 2010 Examiners Report
Page 8
The following will be important:

The management structure used to manage the DSF e.g. number of agents to a
supervisor, the number of supervisors to a branch manager, the number of branch
managers to an area manager and so on.
The level of infrastructure maintained by competitors e.g. size and location of
branches (whether high street or not), type of working (e.g. sales agents may
mainly be on the road with the branches providing flexible office space for a small
proportion of the total number of agents at the branch), the facilities at the
branches and provided to the DSF.
Whether any basic fixed salary is paid to the DSF (the sales people and the
different layers of managers).
Level of productivity measured by number of policies sold per month, average
premium income collected each month.
Average variable commission earned per sales agent per month.
The level and types of incentive schemes used by the competitors to incentivise
performance e.g. membership of special high performer clubs, competitions,
perks on achieving certain sales levels.

The life insurer will need to consider how sales agents will be recruited and trained. In
particular, the insurer will need to consider what proportion of those hired will
actually turn out to be productive agents.

Recruitment and training costs may be significant and the insurer will need to factor
this into the overall costs of establishing a DSF.

Training costs may be heavily influenced by local regulations e.g. there may be a
requirement for each sales agent to receive x hours training, or to pass certain exams
before they are able to sell to the general public. These mandatory training costs need
to be taken into account.

Similarly there may be compliance regulations, such as carrying out background
checks at the recruitment stage, that also need to be taken into account.

There may also be higher ongoing costs in relation to the DSF due to more onerous
regulatory requirements, which would need to be understood thoroughly.
Having assessed the potential development costs, the insurer will need to consider
whether it has the capital (or access to the capital) to establish a DSF.

In particular, the level of capital required may limit the geographical coverage that the
company can achieve or could perhaps limit the number of branches it can afford to
establish initially.

The life insurer will also want to consider whether to do things differently to its
competitors e.g. it may decide to only establish super-branches in key cities, with
most DSF agents working from home.

The life insurer will also need to decide how it will solicit leads in the first place e.g.
through the establishment of a tele-sales unit, since these factors will influence the
infrastructure costs.
Subject ST2 (Life Insurance Specialist Technical) September 2010 Examiners Report
Page 9
The life insurer may be able to save some costs by having less underwriting on the
business sold by the direct sale force compared to insurance intermediaries.

Impact on existing sales channels and quality of business

The DSF may target a different socio-economic class than the existing intermediary
channel.

If this is the case then the insurer will want to consider whether to launch a specific
range of products aimed at this sales channel e.g. with lower sums assured, lower
minimum premiums etc.

Different socio-economic classes generally tend to exhibit different levels of
experience, for example, mortality, different lapse rates, possibly different increment
rates. Also, higher margins may be required in the pricing assumptions due to the
uncertainty in the assumptions as this is a new product to the company. Hence in
order to be able to offer products that are competitive to the existing intermediary
channel it may be necessary to launch separately priced products. The administration
system may need to be changed in order to allow for the differential pricing.

The size of policies written by the direct sales force may be smaller, which may
impact any cross-subsidies previously allowed for.

The life insurer will be particularly keen to understand what its competitors have done
in this regard e.g. whether they have launched differentiated products for this sales
channel and also whether there are any industry statistics e.g. that demonstrate the
different lapse rates experienced by different sales channels.

The life insurer will want to ensure that there is no detrimental impact on its existing
business from the intermediary channel. In particular, it will be important to ensure
that the intermediary channel does not see the DSF as a threat to its own business.
This issue may be largely solved through targeting a different socio-economic class of
policyholders, different geographic regions, possibly where the intermediary channel
is not so strong etc.

Risks

There are specific risks associated with setting up a DSF, the most important being
mis-selling risks. In some markets in the past, when DSFs were common, insurers
have been charged significant sums of money for failing to demonstrate that their
products were well and fairly sold and that the customer understood the product at the
time it was purchased.

Mis-selling risk can only be reduced by ensuring that compliance procedures are tight
e.g. in terms of the paperwork that has to be filled in when a sale is made, and through
regular auditing to ensure that those compliance procedures are followed.

Other risks can be mitigated by aligning policyholder and sales force interests such as
reviewing the commission structure to encourage persistency.

Subject ST2 (Life Insurance Specialist Technical) September 2010 Examiners Report
Page 10
However, given that most mis-selling scandals only became scandals many years after
the sales were made due to a wide variety of factors (consumer pressure, legal and
political environment etc), it is impossible to totally remove mis-selling risk.

DSFs have the ability to ruin an insurers reputation, since the DSF becomes the face
of the insurance company and will be the first point of contact for most customers.
Hence there is a high degree of reputational risk at stake in establishing a DSF.

The life insurer may want to consider the reputation of competitors DSFs and what
those companies have done to achieve those good or bad reputations.

One of the key risks is that the life insurer fails to establish its DSF well and that the
DSF is insufficiently productive. This could lead to the DSF closing after a short
period.

This is a real risk due to the high cost of establishing a DSF (e.g. establishing a branch
network) low volumes sold would not recover these costs.

Setting up a DSF is also difficult without prior experience. One way to mitigate this
risk would be to hire in expertise e.g. recruiting a new sales director from a
competitor with a well established DSF.

Other

The life insurer will consider whether there are any incentives to set up such a sales
channel e.g. tax incentives.

The company may also consider buying a direct sales force rather than trying to
establish one from scratch.

The company would also compare setting up the direct sales force with other
alternative options, such as tied agents or direct marketing.

Generally well answered, though many candidates did not adequately describe items such as
geographical coverage, analysis of competitor direct sales forces and limitations of capital
on plans to set up the DSF. A common mistake made by candidates was to spend time
describing direct sales forces and insurance intermediaries rather than answering the
question being asked.


5 (i) Product features
For both products single or regular premiums could be paid and contracts
could be on a single or joint life basis.

Term assurance
The benefit is payable on death of the life assured, within the term of the
contract.

There is no surrender value payable under the contract and the contract expires
if the required premiums are not paid.
Subject ST2 (Life Insurance Specialist Technical) September 2010 Examiners Report
Page 11
The benefit can be level or decreasing through the term, once chosen at outset,
the insurer cannot alter the benefit or premiums paid by the policyholder.

The contract can be used to provide protection against the financial loss of the
death of a key person or can be used to provide a benefit on death to cover the
outstanding balance on a loan.

The group equivalent of the contract can be used by an employer to provide
benefits to an employees dependants upon the employees death.

The convertible form of the contract allows policyholders to convert their
policy to an endowment or whole of life contract, or to renew their existing
contract. Conversion or renewal would be without the need for further
medical evidence.

Unit-Linked Endowment
The benefit is payable on survival to the end of the term of the contract,
chosen at outset.

A benefit is also provided if death occurs within the term of the contract.

A surrender value would be payable within the term of the contract, subject to
a possible surrender penalty in the early years.

The level of the benefit payable on survival to the end of contract would be
dependant upon the value of units held in a number of unit-linked funds.

The level of the benefit payable on death tends to be a fixed monetary amount
or the value of the units held, if higher.

Charges to cover the cost of any life cover and expenses can be taken from the
premium before being used to purchase units or deducted from units already
purchased. The charges can be guaranteed or reviewable.

The policyholder can select which fund or funds to invest in and can switch
between different funds.

Premiums payable by the policyholder can be flexible.

The product can be used to cover an interest only mortgage.

(ii) Risks to the policyholder in purchasing the product

Either product
There is a risk that the insurer may become insolvent and the dependants may
not receive the full benefit.

There is a potential mis-selling risk that the policyholder did not understand
what they were buying.

Subject ST2 (Life Insurance Specialist Technical) September 2010 Examiners Report
Page 12
Term assurance
The risk to the insured is that the benefit selected at inception turns out to be
insufficient either due to changing circumstances or erosion from inflation.

The policies tend to be inflexible, which means that the product cannot be
altered to meet changing financial needs throughout the contract term.

The policyholder is at risk of not being able to meet premiums due to accident,
sickness and redundancy.

For the convertible form, there is the risk of not being able to afford the new
policy at conversion.

Unit-Linked Endowment
The maturity benefit will have some protection against erosion from inflation,
however the policyholder is subject to risk from poor investment performance
over the term of the contract and at the point the maturity benefits are payable.

Poor investment performance can be due to either general market movements
or poor investment management relative to other companies.

The company may not have sufficient history of selling unit-linked policies so
the historic unit fund performance may not be known, if the funds are
managed internally.

The minimum death benefit tends to be fixed in monetary terms and so could
be at risk from erosion from inflation.

The charges may be variable on the product and the policyholder may be at
risk from unreasonable increases to the level of charges.

There is a risk that the policyholder has to surrender the policy early on in its
term and may as a result receive poor value for money due to high penalties or
front end loaded charges.

(iii) Risk to a company of selling the product

Mortality
The company is at risk from actual mortality experience being worse than that
allowed for in the pricing of the contract. For the term assurance the premium
cannot be changed to allow for this.

The experience may differ due to model risk, parameter risk or random
fluctuations risk.

For term assurance sold to groups of lives, there is the risk from concentration
and aggregation of risk from a large number of claims resulting from a single
cause.

Subject ST2 (Life Insurance Specialist Technical) September 2010 Examiners Report
Page 13
The unit-linked endowment may enable the company to review the mortality
charges applied on the product. However the company may be restricted in
the frequency of the reviews or the level of increase that can be applied.

Related to the mortality risk is an anti-selection risk, particularly for the
individual term assurance product. There is less anti-selection risk for
endowment assurances as these are more likely to have been purchased for
savings rather than protection and are often linked with mortgages.

Expenses and the effect of inflation
There is a risk to the company of actual expenses being higher than those
loaded into the term assurance or unit-linked endowment premium.

There is also a risk that expense inflation is higher than assumed when the
products were priced.

In a similar way to mortality, the company may be able to review the charges
applied on the unit-linked endowment, but may be restricted on the level of
increases by policyholders expectations.

Investment performance
The company is at risk from adverse publicity or poor persistency if the
investment performance on the companys unit-linked funds is worse than its
competitors.

The company is exposed to investment risk under the unit-linked endowment
assurances to the extent that there are any guarantees regarding a minimum
death or maturity benefit. In addition charges linked to the unit funds will also
be reduced as a result of poor investment performance.

There is some investment risk to the company under term assurances, but this
is limited due to the low reserves and likely fixed interest investments.

Withdrawals
The company is at risk from withdrawal experience (lapses on the term
assurance and surrenders on the endowment) being different than that allowed
for in the pricing assumptions.

Higher withdrawals than expected may have a selective effect on the mortality
experience where healthy lives lapse their policy, worsening the mortality
experience on those who remain.

Higher withdrawals may also affect expense experience where fewer policies
remain than expected reducing the companys ability to recoup overhead
expenses.

Higher lapses at the initial durations in force may impact the ability to recoup
initial expenses that were incurred.

Subject ST2 (Life Insurance Specialist Technical) September 2010 Examiners Report
Page 14
Higher than expected withdrawals on the unit-linked endowment assurances
also reduces expected future profit margins.

Higher than expected withdrawals early in the policy term can be a significant
problem under a decreasing term assurance product (where level premiums are
used to support a decreasing benefit).

New business
There is a risk from selling too much new business that may affect the
companys solvency position and administration capabilities.

There is a risk from selling insufficient new business that may affect the
companys ability to recoup expenses.

The company is at risk from the nature and size of contracts being different to
that allowed for in pricing the contract, invalidating any cross-subsidies
allowed for, or increasing the mortality risk.

A change in the mix of new business by source may invalidate the pricing
assumptions used for mortality and expenses.

Guarantees and options
If convertible term assurances are being sold then there is a risk that the cost
of the option loaded in to the premium is insufficient for the level of risk being
taken on.

There is also additional anti-selection risk associated with this option, given
that there is no further underwriting.

Competition
There is a risk that the management may reduce premium rates on the term
assurance in order to gain market share, particularly as the market is likely to
be highly competitive.
There is a risk that the actions of competitors reduce the market share for the
company, impacting upon the companys ability to recoup expenses.

Actions of distributors
There is a risk that distributors may act in their own interests rather than in the
interest of their clients. For example encouraging business to lapse and re-
enter on term assurances.

There is a mis-selling risk due to poorly explained products resulting in
unsuitable sales and the potential for damage to the companys reputation and
regulatory fines.

Counterparties
It is likely that the company will utilise reinsurance to reduce its risk profile,
in particular on the term assurance, this introduces the risk that the
counterparty will default on its commitments.

Subject ST2 (Life Insurance Specialist Technical) September 2010 Examiners Report
Page 15
There will also be default risk on any corporate bonds held to back the term
assurance business, although given the low reserves this may not be
significant.

Other
There is a risk that there may be changes to the legal, regulatory or fiscal
regime that will affect the policyholder and/or the company.

The company is a risk from fraud perpetrated by staff, policyholders or third
parties, for example, fraudulent claims on the term assurance.

The company is also at risk from failure of systems and controls and from data
errors.

This question was generally well answered, parts (i) and (iii) more than part (ii).


6 (i) The aggregate asset shares at the year end are calculated from the following
formula:

Aggregate asset shares at start +premium income +investment income
initial expenses renewal expenses commission claims shareholder
transfers

Working in $000:

Total asset shares at start =70,000
Investment income =4,300
Premium income =15,000*600/1,000+2,000*700/1,000 =10,400
Initial Expenses =1,500
Renewal expenses =510
Renewal commission =10,400*.02 =208
Claims =(150*6,000+60*5,500+5*4,000)/1,000 =1,250
Shareholder transfers on declared bonuses =
0.04*[(10,000150)*5,000+(5,00060)*4,500+(2,0005)*3,500)/1,000/9
=348.7
Shareholder transfers on TB on death =
(150*1,000+60*1,000+5*500)/1,000/9 = 23.6
Total =80,860, i.e. $80.86 million

(ii) To determine the mortality factor to use:
Expected deaths =.02*10,000+.01*5,000+.007*2000 =264
Actual deaths =150+60+5 =215
Factor F =215/264 =0.81439

(iii) Working in $000:

To determine the investment rate to use for individual asset shares:
(70,000+10,4001,500208510)*i =4,300
i =5.5%
Subject ST2 (Life Insurance Specialist Technical) September 2010 Examiners Report
Page 16
Now working in $:

Renewal expenses per policy =510,000/17,000 =30
Initial expenses per policy =1,500,000/2,000 =750

Individual asset shares are calculated using the following:

(Asset share at start +premium income +investment income initial expenses
renewal expenses commission death rate * (death outgo +shareholder
transfers on TB paid)/(1- death rate) shareholder transfers on declared bonus

Note that shareholder transfers on declared bonuses are after death claims and
so are not grossed up for deaths.

Cohort A:

Death rate =.02*0.81439

((5,000+600*.9830)*1.055(6,000+1,000/9)*0.81439*.02)/(10.81439*.02)
.04*5,000/9 =5,837

Cohort C:

Death rate =.007*0.81439

((0+700*.9830750)*1.055(4,000+500/9)*
0.81439*.007)/(10.81439*.007) .04*3,500/9 =139

For information (no marks)

Cohort B:

Death rate = .01*0.81439

((4,000+600*.9830)*1.055 (5,500+1,000/9)*
0.81439*.01)/(10.81439*.01) -.04*4,500/9 = 4,782

(iv) The sum of the individual asset shares is (in $000):

5,837*9,850+4,782*4,940139*1,995 =80,840

This differs very slightly from the aggregate asset shares due to the
approximation in the death rates applied to the individual asset shares.

Factors implied for each cohort :

A: 150/10,000/.02 =0.75
B: 60/5,000/.01 =1.2
C: 5/2,000/.007 =0.36

Subject ST2 (Life Insurance Specialist Technical) September 2010 Examiners Report
Page 17
To apply separate factors to every mortality rate would be like deriving a
company specific mortality table.

This is likely to become volatile year on year and also impractical for systems.

Using the individual asset shares (with F factor) means that mortality
experience is smoothed.

Using the F factor shares mortality risks between cohorts, which is consistent
with the idea of pooling risks using the additions to benefits method.

As aggregate asset shares and sum of individual asset shares are close then
using individual asset shares to determine payouts will result in total payouts
being close to the available asset share and hence little change in free assets.
However, there will have been some cross-subsidy between cohorts.

In addition the data could be spurious, with some rates being zero for cohorts
in certain years.

This could make asset shares for very similar cohorts different for no easily
explainable reason.

If the company wanted there to be no impact of mortality differences they
could find the death factor by back solving to get the same answer, but this
could be complex.

A simple factor applied to all asset shares to eliminate the difference could be
an alternative. This has the advantage of being simple to apply across all
products and ensures that the difference between actual and expected deaths is
spread across all business. In the above example the factor would be
80,860 / 80,840 =1.0002

Care would have to be taken that any other differences between the sum of the
individual asset shares and the aggregate assets were not mistakenly classed as
mortality differences when adjustments are made.

Part (i) was well answered although many candidates failed to write out the formula for the
asset shares and hence their solutions were, in some cases, difficult to follow. Part (ii) was
very well answered by those that attempted the question. Part (iii) was not well answered.
Better candidates appreciated the need to use the factor F derived in part (ii) in the solution
to part (iii). Part (iv) was very poorly answered, however those candidates that made
reasonable attempts at parts(i) and (iii) were able to describe the differences between the
two.


END OF EXAMINERS REPORT