THE UNIVERSITY OF NEW SOUTH WALES

SEMESTER 2 2017

ACTL4002 / ACTL5200

ACTUARIAL THEORY & PRACTICE B

MID SEMESTER EXAMINATION

1) TIME ALLOWED – 1 HOUR.

2) READING TIME – 5 MINUTES

3) THIS EXAMINATION PAPER HAS 3 PAGES

4) TOTAL NUMBER OF QUESTIONS 3

5) TOTAL MARKS AVAILABLE – 36

6) ALL QUESTIONS ARE OF EQUAL VALUE.

7) THE PAPER MAY BE RETAINED BY THE CANDIDATE.

8) CANDIDATES MAY BRING IN THEIR OWN UNSW APPROVED

CALCULATORS.

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Question 1 [12 marks]

Wikipedia says the following about the European embedded value (EEV) published by life
insurers:

“EEV can be "real world" or "market consistent". The former takes the best estimate for
parameters that are available, whereas the latter uses a slightly constrained set of
parameters which are close to best estimate, but which produce results which match
market-related hedge costs.

Real-world EEV usually uses a risk discount rate made up of the risk-free rate plus a risk
margin which reflects the weighted average cost of capital and Beta from the CAPM model.
Using company-level economic models clearly reflects a top-down approach to determining
the risk discount rate.

Market-consistent EEV makes use of a bottom-up approach for determining the risk
discount rate, which produces a number which equals the risk free rate plus an explicit
allowance for operational risk and market risk. Commented [AA1]: This is a little confusing. Market risks are
not normally added to market consistent discount rates.

Although initially there was an equal use of these two types of EEV, as time passes
companies appear to be moving towards the market-consistent approach.”

The Prudential Life Insurance company of the UK published its EEV with the following note
explaining the basis: “Results prepared under the EEV principles capture the discounted
value of future profits expected to arise from the current book of long-term business. The
results are prepared by projecting cash flows by product, using best estimate assumptions
for all relevant factors. Furthermore, in determining these expected profits full allowance
is made for the risks attached to their emergence and the associated cost of capital, taking Commented [AA2]: Ie the risks are determined globally for the
cash flows by product group and not bottom up for each different
into account recent experience in assessing likely future persistency, mortality, morbidity element - persistency etc.
and expenses.

a) State with reasons whether the Prudential is using a real-world or market consistent
basis. (2)

b) The items overleaf are extracted from the Prudential’s 2015 EEV value report. Briefly,
explain each of the numbered items (in groups if possible), saying what each can tell Commented [AA3]: Many of you lost marks by not explaining
or merely repeating the descriptions
about the Prudential’s business. (10)

2
 2015 £m
INSURANCE PROFIT (LOSS) ANALYSED FROM: Commented [AA4]: is income statement not balance sheet
1 Asia operations
2  New business 1,490
3  Business in force 831
4 US operations
5  New business 809
6  Business in force 999
7 UK operations
8  New business 318
9  Business in force 545
EFFECT OF ACTUAL INVESTMENT RETURNS Commented [AA5]: I added this heading, but it misled some of
you into thinking that item 10 was mainly investment returns, but it
10 Operating profit based on longer-term investment returns 4,881 just says using long term returns – see below. Most of the profit
11 Short-term fluctuations in investment returns (1208) comes from new business – as can be seen above. (I gave marks to
those who thought it was mainly investment returns.
ANALYSIS OF ASIAN BUSINESS IN FORCE
12 Unwind of discount and other expected returns 749 Commented [AA6]: Some suggested that these arose from
short term assets – highly unlikely If you really think about it.
Commented [AA7]: The present value of future profits from
13 Effect of changes in operating assumptions: 12 existing business is determined at the cost of capital so that as time
14  Mortality and morbidity 63 elapses the discount rate unwinds and is added to profit. In
addition, there is capital that is released and there might be other
15  Persistency and withdrawal (46) margins that are released – like MOS.
16  Expense (1) Looked at another way, the long term return on assets is at a higher
rate than the liabilities are growing so that a margin emerges over
17  Other (4) time from investments – and any other conservative assumptions

18 Experience variances and other items: 70

19  Mortality and morbidity 58
20  Persistency and withdrawal 20
21  Expense (32)
22  Other including development expenses 24

23 Total Asia operations 831

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Marking guide

a) Real world with best estimates and discounts profits (ie sum of cash flows) for cost of
capital that is adjusted for the cost of capital ie. WACC, which includes allowance for
all risks. They actually use product related betas. It is not necessarily inconsistent
with the market.
Market consistent adjusts each cash flow for their specific risk and discounts at risk
free rate – with company specific allowances.

b) NBus represents pv of 2015 new business under existing assumptions

– New business is being written on very favourable terms.
BIF represents profits from existing 3=23
very much larger in Asia; US and UK more mature – (Asian market >> US >> UK)

c) The business in force yields a profit from:

Expected return - of discount rate of EEV and other loadings (12)
Plus changes in assumptions (13=Σ(14-17)
good insurance, poor lapses
Plus experience profits (18=Σ(19-22)
expense losses – profits from others
Last year’s investment returns lower than LT assumptions as a result of ST volatility
12+13+18=23

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Question 2 [12 marks]
A small general insurer XYZ sells retail business only and operates in a country with minimal
prudential regulation. It is analysing its performance in the last year and believes its risk
appetite statement is unclear. The business plan is to grow its small market share as rapidly
as possible.

(a) Briefly describe the company governance policies that support its management of risk?
(2)

(b) You have been appointed chief risk officer, and the directors have asked you to draft a
new risk appetite statement that better encompasses the risks associated with their
business. It should include an overall statement of the risks and a table of risks ,
including high level risk categories, specific risks and tolerances. Draft this document, Commented [AA8]: “Draft” not “describe”. These are mini-
case studies asking you to apply your knowledge to a concrete
giving four main risks in the table. You should use your imagination to fill in any details situation. They test whether you are reading with understanding
about the company’s business plan that you need for the task. (10) Commented [AA9]: Ie be practical …

Marking guide:

(a) risk management strategy and risk management framework

(b) XYZ will underwrite general insurance business that is well understood and priced such
that customer service is high quality and it delivers an appropriate rate of return on
shareholder capital. (2 marks)

High level category Specific risk Tolerances

Insurance risks Outstanding claim risk Board expects management Commented [AA10]: This is GI company so talk about
policyholders’ heath is irrelevant and suggests that you are not
to avoid significant reserve addressing the question but regurgitating facts
strengthening ( Tolerances
Green <2%, Amber 2-5%, Red
>5%)
Catastrophe risk Board expects management
to …etc
Investment risks Market risk <10% of assets
Credit risk Min BBB
Operational risks People risk
IT risk
Strategic risks Competitor risk
External risks Political risk
Legislative risk
Etc more possibilities

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Question 3 [12 marks]
You are an actuary who works in the credit risk team of a large Australian bank that covers
both retail and business loans.

a) You have been asked to apply the UK Technical Actuarial Standards to the data that Commented [AA11]: The data comes mainly from your bank –
questions about the legitimacy of the source is not relevant
the team is using. Outline how you would do this. (6)
b) The Reporting Standard “requires an indication of the nature and extent of any
material uncertainty inherent in the information contained in an aggregate report.”
Set out what items would be used to communicate the uncertainty in the credit risk Commented [AA12]: Not the items that are uncertain, but that
give an indication of the uncertainty
for loans to small businesses. (3)
c) In terms of the The Anti-Money Laundering and Counter-Terrorism Financing Act
2006, Australian banks are required to “Know Your Customers” (denoted as “KYC”).
What information would the credit department have available that would be
particularly relevant to this requirement? Outline how you might check whether Commented [AA13]: Ie the actuary in the credit risk team, who
is working on AML reporting
different bank branches around the country are applying the same KYC standards?
Commented [AA14]: This means your bank’s branches – not
(3) those of another bank.

Part a

 Modelling output:
o 99.5% VaR for

Part b

 outliers
o high LVR – loan/house prices
o low salary
 spot checks
o check data quality
 check for missing values
 assumptions
o lgd
o pd
o ead
o assumptions for homogenous groups
o check that groups follow requirements/are reasonably homogenous
 documentation
o changes, source, methodology, errors, definition
 reconciliation
o compare against a source of truth
 compare to general ledger
o compare versus last year

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Part c

Marking guide;

a) Data – is best available and checked for accuracy, grouped appropriately (1.5)

Loans outstanding build up from year to year and reconcile Commented [AA15]: This is about credit risk so your answers
need to mention the specific data that you would use.
Collateral values/losses are checked randomly – reconciled with inflation/market
Other customer information is complete, consistent / no outliers
Checks are made for homogeneity of groups
Outliers investigated/rejected
Source, checks and judgments documented so that person unfamiliar with data can
perform them (2)

b) The uncertainty inherent in point estimates of PD, LGD might be indicated through
the use of ranges, sensitivity analyses or other means.
Show impact of changes in PD, LGD on credit losses
Historical cycles need to be illustrated
c) Need to have proof of ability to pay, Salary for individuals and business solvency Commented [AA16]: The question just asks what the credit
department would hve for KYC
Large and irregular withdrawals and repayments
Is the information on these data items consistent across branches? Commented [AA17]: This would be critical information, but the
bank would also need to look at all accounts. I did give a mark for
this.
Commented [AA18]: Someone suggested a mystery borrower
exercise but that’s not the actuary’s normal job. We check data.
END OF PAPER