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Subject ST7
CMP Upgrade 2013/14
CMP Upgrade
This CMP Upgrade lists all significant changes to the Core Reading and the ActEd
material since last year so that you can manually amend your 2013 study material to
make it suitable for study for the 2014 exams. It includes replacement pages and
additional pages where appropriate. Alternatively, you can buy a full replacement set of
up-to-date Course Notes at a significantly reduced price if you have previously bought
the full price Course Notes in this subject. Please see our 2014 Student Brochure for
more details.
Changes to the ActEd Course Notes, Series X Assignments and Question and
Answer Bank that will make them suitable for study for the 2014 exams.
Chapter 3
Page 37
A new paragraph of Core Reading has been added, which discusses the use of
telematics in motor business.
We recommend that you remove pages 3738 from your Course Notes and use
replacement pages 37, 38a, 38b and 38c provided below.
Chapter 6
Page 20
We recommend that you remove pages 1920 from your Course Notes and use
replacement pages 19, 20a, 20b and 20c provided below.
Chapter 8
Page 1
Page 4
Page 10
Chapter 9
Page 8
A new list has been added after the first paragraph on page 8. This reads:
Reserves booked will usually be greater than best estimate due to:
smoothing of results
difficulty in setting reserves, particularly reinsurance recoveries
requirements of regulatory bodies
peer pressure.
Page 17
A new portion of Core Reading has been added, which discusses uncertainty arising
from the treatment of large losses.
We recommend that you remove pages 1516 from your Course Notes and use
replacement pages 15, 16a, 16b and 16c provided below.
Page 28
A new sentence of Core Reading has been added, at the end of the section on broker
mergers. This reads:
This can be a particular issue for commercial risks where both insureds and
brokers are far bigger than the insurers.
Chapter 10
Page 4
Page 7
A new use of data has been added to the list of bullet points:
catastrophe modelling.
Page 10
Two new users of data has been added to the list of bullet points:
risk management
catastrophe modelling.
Page 11
Example
In the UK, an insurer should have kept at least enough data to be able to compile
the statutory returns to the PRA (Prudential Regulation Authority). There are
similar requirements in some other countries.
Page 15
Page 16
The former will provide claims details to be entered onto the insurers systems
or onto bordereaux, while claims from the latter will be entered by the insurers
own staff.
Page 17
A new sentence has been added before the first paragraph of ActEd text. This reads:
Both premiums and claims information may be bulk figures, and thus policy and
claims details are hard to access.
It may be time consuming for staff to enter such data into a computer system
and so only major losses may be broken out from claims bordereaux, with the
residual being entered as a bulk item. It is quicker to integrate data received
electronically into the system.
Page 18
The last sentence in the paragraph discussing length of tail now reads:
This is particularly true of classes that are subject to significant delays in claim
notification or slow loss development.
But the fact that the information will vary from risk to risk does not lend itself to
systematic data capture; often this is the case with London Market data.
Page 21
A new sentence has been added after Question 10.8. This reads:
Clear links are needed between underwriting and claims databases eg via policy
reference numbers.
Page 22
Written premiums are the premiums an insurer expects to receive over the
duration of the policy. Written premiums may be before or after commission.
The insurer should calculate the net written premiums by deducting any
reinsurance premiums from the gross premiums.
Page 26
Page 28
Page 29
This is likely to occur some time after the original claim payments are made and
the amounts are normally recorded as negative claim payments with a code to
identify the type of receipt so that claim severities can be better assessed.
Page 30
for a claim made by a minor who can reclaim on attaining the age of 18.
Page 31
A new sentence has been added to the end of the second paragraph, which reads:
Inwards claims are likely to have a catastrophe indicator and recoveries may be
proportional.
A new discussion has been added to the end of the section on reinsurance recoveries.
This reads:
The amount of the reinstatement premium would therefore be allocated to the claim(s)
that had necessitated the use of the reinstatement cover.
It is unlikely that one will allocate IBNR and paid claims to individual risks except
for large London Market contracts.
Page 39
A new sentence has been added to the end of the section on check digits. This reads:
Chapter 12
Page 9
A new sentence has been added to the final paragraph of Core Reading. This reads:
The level of regulatory capital required to support the business may also be
considered.
Page 12
Chapter 13
Page 9
Using this cohort, we group claims according to the year (or other period /
cohort) in which they are reported to the insurer or reinsurer, irrespective of the
original period of the claim event or when the insurance policy incepted.
Page 12
A new paragraph has been added before the section on prioritising work / materiality.
This reads:
It should also be noted that the selected development period does not need to
be the same length as the selected cohort period. For example, projections of
underwriting year cohorts showing quarterly development periods are common.
Page 16
Two more examples have been added to the top of the page. These are:
Page 26
A fourth bullet point has been inserted into the list. This reads:
Therefore, the first sentence of Core Reading after Question 13.12 now reads:
The first four examples above might be expected to cause a one-off change in
the way that claims develop.
A new sentence has been added to the bottom of page 26. This reads:
For some changes in claims handling procedures, which only affect the
development of incurred claims, it may be appropriate to rely more heavily on
paid development data for the projection.
Page 27
The second paragraph under the section on claims reviews now reads:
However, if such reviews are infrequent, or if a large one-off review has been
carried out, or if the company undertakes the reviews more frequently than it has
in the past, it may be necessary to adjust the development pattern derived from
the data.
Page 28
Seasonality can also impact the speed at which claims are processed for
example, fewer claims may be processed during December when there are a
greater number of Bank Holidays.
Page 39
A new sentence has been added before Question 13.18. This reads:
Page 40
...if conservative case reserves are set up at the outset or if case reserves are
held for claims which subsequently settle for nil.
Page 44
We can also use curve fitting to smooth development patterns or to select a tail
factor to allow for development beyond the oldest development period.
Page 48
A new sentence has been added under the first paragraph of Section 3.4. This reads:
Page 59
We note that the definition of claim numbers affects the average claim sizes.
For example, whether nil claims are included or excluded will affect the selected
average claim sizes (all other things being equal). It is of utmost importance to
ensure that the claim frequency and claim severity are consistent.
Page 61
A new bullet point has been added to the list of strengths. This reads:
Page 69
In determining the need for an additional reserve the extent to which different
categories of business can be aggregated should be considered, such that
anticipated future profits from some categories of business may offset potential
inadequate premiums in other categories.
Chapter 14
Page 2
Two new points have been added to the first list of bullets. These are:
Page 4
A new bullet point has been added to the bottom of page 4. This reads:
Page 30
A new bullet point has been added to the list. This reads:
Stress and scenario tests around the most significant assumptions and
key areas of uncertainty.
Chapter 15
Page 14
Page 21 22
New Core Reading has been added to Section 5.2 and a new section has been added
discussing the reserving cycle.
We recommend that you remove pages 2122 from your Course Notes and use
replacement pages 21, 22a, 22b and 22c provided below.
Page 25
Chapter 17
Page 3
Page 4
earnings inflation, medical inflation and judicial inflation will affect bodily
injury claims for liability business.
Page 6
In the third paragraph of Core Reading, the first sentence now reads:
The way in which an insurer chooses to invest the assets supporting the free
reserves will be influenced by the size of the free reserves, and by permissible
holdings based on the regulatory regime to which the insurer is subject.
Page 10
Page 22
Page 29
The insurer could then attempt to reduce this probability to an acceptable level.
However, it is highly dependent on the chosen probability distribution functions,
and other assumptions such as those around dependencies between risk types,
products and so on.
Page 36
A new section on reverse stress and scenario testing has been added. We recommend
that you insert new pages 36b and 36c below into your Course Notes.
Chapter 21
Page 12
The third and last paragraphs of Core Reading now refer to the PRA instead of the
FSA.
Chapter 23
Page 7
Chapter 24
Pages 2 and 4
New Core Reading has been added to pages 2 and 4. We recommend that you remove
pages 1 4 from your Course Notes and use replacement pages 1 4c below.
Page 8
A new bullet point has been added to the list on page 8. This reads:
Page 9
We may deem the unearned premiums less deferred acquisition costs carried
forward to be insufficient to cover the cost of the claims and expenses that will
be incurred in the period of unexpired risk. That is, if we wrote a potentially
lossmaking contract (onerous contract) in the previous period, then not only
will we need to recognise any premium to be earned in a future year, but we will
also recognise the reserve that we need to put aside to cover the risk that we
undertook: We should therefore establish an additional reserve for unexpired
risk.
The excess of that reserve over any corresponding reserve at the end of the
previous year will form part of the outgo in the latest accounting year.
Page 17
The Core Reading on IFRS and UK GAAP has been updated. We recommend that you
remove pages 17 18 from your Course Notes and use replacement pages 17 18c
below.
Chapter 25
Page 2
Page 3
Further explanation of IFRS Phase II has been added. We recommend that you remove
pages 3 4 from your Course Notes and use replacement pages 3 4c below.
Page 8
Further Core Reading has been added. We recommend that you remove pages 7 8
from your Course Notes and use replacement pages 7 8 below.
Chapter 26
Page 9
The deadlines on this page have been amended. We recommend that you remove pages
9 10 from your Course Notes and use replacement pages 9 10 below.
Glossary
Page 1
an example being the Claims Reserving Manual published by the Faculty and
Institute of Actuaries.
Page 7
Page 10
Page 14
The definition of deferred acquisition costs has been updated. The first sentence now to
reads:
Page 18
In the definition of experience rating, the end of the first paragraph now reads:
Page 19
The definitions of Financial Services and Markets Act 2000 (FSMA)* and Financial
Services Authority (FSA)* have been deleted.
Page 20
Fronting
In insurance the term fronting may also be used to describe the process
whereby an individual effects a policy for him/herself but tries to save money by
putting the policy in someone elses name.
Page 39
In the definition of required solvency margin, FSA has been changed to PRA.
Page 46
Pages 48 52
The following items have been deleted from the list of abbreviations:
Chapter 1
Page 27
Chapter 2
Page 19
For example, the European Court of Justice recently ruled that a persons sex can no
longer be used to calculate insurance premiums.
Chapter 3
Page 37
A new paragraph of ActEd text has been added, to follow the new Core Reading on the
use of telematics in motor business.
As stated above, we recommend that you remove pages 3738 from your Course Notes
and use replacement pages 37, 38a, 38b and 38c provided below.
Chapter 6
Page 19
A new explanation has been added to the penultimate bullet of page 19. This reads:
For example, under the EU Gender Directive, European insurers are no longer allowed
to use gender as a rating factor. (This is discussed further below.)"
Pages 20-21
A new ActEd discussion has been added to supplement the new Core Reading on the
EU Gender Directive.
As stated above, we recommend that you remove pages 1920 from your Course Notes
and use replacement pages 19, 20a, 20b and 20c provided below.
Chapter 9
Page 3
Page 17
A new ActEd discussion has been added to supplement the new Core Reading on the
uncertainty arising from the treatment of large losses.
As stated above, we recommend that you remove pages 1516 from your Course Notes
and use replacement pages 15, 16a, 16b and 16c provided below.
Chapter 10
Page 11
The PRA is one of the successors to the FSA (Financial Services Authority), with
effect from 1 April 2013. Amongst other things, it is responsible for the supervision
and regulation of insurance companies in the UK.
Page 31
A new discussion has been added to the end of the section on reinsurance recoveries.
This reads:
The amount of the reinstatement premium would therefore be allocated to the claim(s)
that had necessitated the use of the reinstatement cover.
It is unlikely that one will allocate IBNR and paid claims to individual risks except
for large London Market contracts.
Page 51
The final paragraph in the section on uses and users of data now reads:
The full development team for a computer system should include senior management,
accountants, underwriters, claims managers, marketing, investment, computing staff,
risk management staff, catastrophe modellers and reinsurers, as well as actuaries.
Page 56
Two more points have been added to Solution 10.5. These are:
Risk management: monitoring the size and nature of risks written, identifying
aggregations of risk, implementing risk controls
Catastrophe
modelling: assessing and quantifying catastrophe risks.
Chapter 13
Page 89
Chapter 14
Page 36
A new point has been added to the last list of bullets. This reads:
Chapter 15
Page 14
An ActEd explanation has been added to the new Core Reading bullet point. This reads:
Page 21 22
ActEd text has been added to help explain the new Core Reading.
As stated above, we recommend that you remove pages 2122 from your Course Notes
and use replacement pages 21, 22a, 22b and 22c provided below.
Page 28
Page 31
In Solution 15.8, the development factor for 2008, development period 1 has been
corrected to 1.284 instead of 1.294.
Chapter 21
Page 12
A new sentence of ActEd text has been added after the third paragraph of Core Reading.
This reads:
The Board for Actuarial Standards (BAS) has now been replaced by Financial
Reporting Council (FRC) Board.
Chapter 24
Pages 17
Additional ActEd text has been written to supplement the new Core Reading on IFRS
and UK GAAP.
As stated above, we recommend that you remove pages 17 18 from your Course
Notes and use replacement pages 17 18c below.
Part 2
Part 3
The end of Question 3.10 part (iv) has been corrected to read:
... calculate a revised estimate of the ultimate gross claim payments for the 2012
accident year.
Part 4
In Solution 4.17 part (ii), the third bullet point now refers to the PRA instead of the
FSA.
In Solution 4.22 part (ii), the last bullet point now refers to the PRA instead of the
FSA.
Part 6
Question 6.18 part (ii) has been corrected. We recommend that you remove pages 7 8
from this Q&A bank and use replacement pages 7 8 provided below.
In Solution 6.11 part (iii), the last two bullet points have been updated to say 2014 and
2016 respectively.
Assignment X1
Part (iii) of Question X1.8 has been deleted and a new Question X1.9 has been written.
We recommend that you remove pages 3 4 from your X1 Assignment and use
replacement pages 3 4 provided below.
Part (iii) of Solution X1.8 has been deleted and a new Solution X1.9 has been written.
We recommend that you remove page 15 16 from your X1 Assignment and use
replacement pages 15 16 provided below.
Assignment X2
Question X2.3
A rich friend of yours has just become a Lloyds Name. He has joined a syndicate that
writes only marine insurance. List sources of risk and uncertainty which will affect the
return that he makes from his capital outlay. [6]
Solution X2.3
This has been replaced with a new solution. We recommend that you remove
page 3 4 from your X2 Assignment and use replacement pages 3 4 provided below.
Assignment X3
Solution X3.5
In part (ii), one of the headings in table has been corrected. It now says Percentage
developed instead of Grossing up factor.
Assignment X4
Question X4.4
Give reasons for correlations between different lines of business and describe how
allowance can be made for correlations within a stochastic model. [4]
Solution X4.4
This has been replaced with a new solution. We recommend that you remove
page 3 4 from your X Assignment and use replacement pages 3 4c provided below.
Assignment X6
Question X6.2
This question has been rewritten. We recommend that you remove page 1 2 from
your X Assignment and use replacement pages 1 2 provided below.
Solution X6.2
This has been replaced with a new solution. We recommend that you remove
page 1 4 from your X Assignment and use replacement pages 1 4c provided below.
For further details on ActEds study materials, please refer to the 2014 Student
Brochure, which is available from the ActEd website at www.ActEd.co.uk.
5.2 Tutorials
For further details on ActEds tutorials, please refer to our latest Tuition Bulletin, which
is available from the ActEd website at www.ActEd.co.uk.
5.3 Marking
You can have your attempts at any of our assignments or mock exams marked by
ActEd. When marking your scripts, we aim to provide specific advice to improve your
chances of success in the exam and to return your scripts as quickly as possible.
For further details on ActEds marking services, please refer to the 2014 Student
Brochure, which is available from the ActEd website at www.ActEd.co.uk.
If you have any comments on this course please send them by email to ST7@bpp.com
or by fax to 01235 550085.
Motor property
The term black box here doesnt refer to a box that is black (although it might be!).
Rather, it is a device or system that is placed in a motor vehicle to monitor the way in
which the vehicle is driven. It can measure speed, acceleration, braking, etc as well as
monitoring exactly when the vehicle is driven. Its called a black box because we will
generally know very little about its inner workings.
Question 3.17
Name some other risk factors for motor insurance that can also be used as rating factors.
Question 3.18
State whether the following risk factors are likely to affect the frequency of claims, the
size of claims, or both:
(i) where the car is driven
(ii) how expensive the car is to replace / repair
(iii) how fast the car is driven.
Type of cover is the most important rating factor, as varying the type of cover
can exclude an entire class of claims.
For example, third party cover will not include any claims for accidental damage to the
insureds own vehicle.
Policy excess is also an important rating factor as it too will affect claim sizes.
Other rating factors are proxies for those risk factors for which direct
information is unreliable. These include:
the use to which the vehicle is put (eg for business use)
the age of the vehicle
the occupation of the policyholder and other drivers
whether there are additional drivers of the vehicle as well as the
policyholder
sex of main driver
age of policyholder and other drivers
whether or not driving is restricted to certain named drivers
make and model of vehicle
the extent of any modification to the engine or body
location of policyholder (eg postal code)
where the vehicle is kept overnight: on the road / on a driveway / in a
garage etc
whether or not the driver has any driving convictions
past experience.
Question 3.19
The age of the policyholder and the address of the policyholder are proxies for which
risk factors?
This page has been left blank so that you can slot the replacement pages
into your Course Notes.
Why should insurance business suffer more legislation than, say, umbrella
manufacturers? One of the reasons is that there is more scope for the purchaser to lose
out financially. When you buy an umbrella, you have a look at it, and if you like it, you
pay the price. However, with insurance, you pay the price at the start of the contract
and you have to trust the insurer to pay valid claims as and when they arise in the future.
The uncertainty underlying insurance business means that it is not just a question of
trusting the honesty of the insurer. The insurer may be very well meaning, but if the
insurers business is not soundly managed, you may find that the insurer has collapsed
by the time you need to make a claim.
In many countries, therefore, there are specific rules and regulations that apply to
general insurers. Different countries adopt different approaches to the regulation of
insurers operations.
Question 6.9
EU Gender Directive
The EU Gender Directive was passed in 2004, being aimed at implementing the
principle of equal treatment between men and women in the access to and
supply of goods and services.
However, insurance companies are careful to avoid the use of proxy rating
factors (ie highly correlated to gender) that might be deemed to be indirect
discrimination and thus also not permitted.
Clearly, the inability to differentiate between gender when setting premium rates
is having significant implications for insurance pricing, particularly for motor
insurance where there are material observed differences in claims experience
according to gender at certain ages.
Each insurer is likely to set premium rates based on the expected mix of business by
gender but there is the risk that the mix of male / female policyholders turns out not to
be as expected. The introduction of this legislation has therefore increased the
uncertainty of insurers claims experience and profitability.
It is not yet clear how premium rates or underwriting practices have changed as
a result of the ruling. However it is likely that premiums have not simply met in
the middle, but that there have been additional contingency loadings for the risk
of business mix by gender not being as expected within the unisex pricing.
In other words, this legislation has also led to increased uncertainty in premium rates, at
least in the short term, and hence higher risk margins being charged by insurers.
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into your Course Notes
A number of the variables in the model will be correlated with one another; for
example, interest rates and claims inflation.
Question 9.10
Example
If claims handlers have under-reserved a case in the recent past, they may be
inclined to overestimate future claims to compensate.
This could involve a change in reserving methods, or a change in the basis used for the
reserve estimates (within an acceptable range).
This increases the difficulty of selecting appropriate parameters with which to model
the business.
Large claims
Example
A large windstorm claim may develop at a different rate to a large flood claim,
although both types of claim may be experienced in a property book.
It is normal practice to remove large claims from the development and project
these separately.
Uncertainty may also arise in how a large claim is defined. They could be
defined as claims over a particular threshold limit (possibly with a different
threshold for different perils, often set to achieve sufficient data and with an eye
on the reinsurance programme), or large claims may be a subjective
management decision.
If the threshold for what constitutes a large claim is too low, then a large quantity of
data will be excluded from the attritional claims triangulation, and this will result in the
triangulation data (and the reserve estimates) being less credible.
However, if the threshold is set too high, then more large claims will be included in the
attritional triangulation data, and this will increase the volatility of the projection.
In practice, the definition of a large claim might be set at the retention limit for the
non-proportional reinsurance programme. This would make a projection of net of
reinsurance claims much easier. (Reinsurance reserving will be discussed in
Chapter 23.)
On some occasions, there may be an absence of large reported claims, and the
reserving actuary may wish to add a loading to reflect this fact. This will give
rise to additional uncertainty.
Catastrophes
Catastrophic losses can take the form of one immense loss, such as an oil-rig explosion.
Alternatively, there may be many smaller insured losses, all stemming from a common,
identifiable event such as a hurricane.
One way to reduce the impact of catastrophic losses is to write business in a wide range
of geographical locations and across many classes. Catastrophe reinsurance will also
help (more of this later in the course).
Latent claims
Catastrophic claims can also result from sources that were unknown, or for which a
legal liability was not expected, at the time of writing the business. The cost of such
claims cannot be calculated with any accuracy for the purpose of setting reserves.
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into your Course Notes
The speed at which the bottom of the cycle is reached and rates begin to harden
is often increased by external factors such as large catastrophe claims, which
can reduce profitability and increase the pressure on rates to harden. Rates then
continue to increase (harden) until we are back in a hard market and the process
starts all over again.
The length of the underwriting cycle varies by class of business and territory. For
example, in some UK personal lines classes, it is around seven years. It will be
dependent on, for example:
macro-economic effects, eg people pay less for insurance and claim more when
economic conditions are poor
investment conditions (if it is expected that good returns can be made on
invested premiums then the insurer may be prepared to offer softer premium
rates)
major industry losses, eg natural disasters or terrorism.
The underwriting cycle can have an influence on claims development. For example in a
hard market, individuals who perceive themselves as low-risk may choose to self-insure
rather than pay high premiums, resulting in anti-selection against the insurer.
One way to allow for the underwriting cycle in reserving exercises is to use a
rate index when deriving the initial expected loss ratios for use in credibility-type
methods.
Rate indices are typically only available for renewal business and
therefore may not adequately allow for any differences between new and
renewed business.
In an ideal world any rate index should attempt to take account of these
changes, which are inevitably more difficult to quantify than pure changes
in the premium charged.
Question 15.11
This appears to show that in a soft market, incurred claims development patterns
are slower to develop (or longer-tailed) than in a hard market so that an
unadjusted projection can underestimate ultimate claims in a soft market (and,
equivalently, overestimate them in a hard market, when insurers can afford it).
The initial expected loss ratio can be chosen to take account of changes in the reserving
cycle as well as changes in the underwriting cycle.
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into your Course Notes
Reverse stress testing differs from general stress and scenario testing in that the
starting point is the assumed outcome of business failure, thus the exercise
being the identification of circumstances where this might occur, whilst the latter
looks at the resulting outcomes arising from specified changes in
circumstances.
In other words, a reverse stress and scenario test identifies the circumstances / model
assumptions required for the business to fail.
This is in contrast to the more common use of a stress or scenario test which analyses
the effect on the business of a given set of circumstances / assumptions.
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Course Notes
Chapter 24
Accounting methods
Syllabus objectives
(u)(i) Describe the methods and principles of accounting for general insurance
business and interpret the accounts of a general insurer.
0 Introduction
There are two distinct methods used by general insurers to present their accounts:
annual (or accident year) accounts, which consider all income earned and outgo
incurred in a year and permit the release of profits at the end of that year
funded (or underwriting year) accounts, which consider the business written in
each year and do not permit the release of profits until the end of a subsequent
year (usually the third year).
Section 1 gives a broad overview of the two methods, which are then discussed in detail
in Sections 2 and 3. In Section 4 we discuss whether the accounts of a general
insurance company reflect the true underlying profitability of the company. Section 5
goes on to explain how to construct simple accounts.
This chapter contains a lot of additional explanation and a number of questions, to help
illustrate the Core Reading and explain how these principles work in practice.
1 Methods of accounting
Annual accounts are usually used for most forms of direct insurance (eg motor,
household, employers liability, commercial property).
Under annual accounting, we consider all income earned and outgo incurred in a
year and can release profits at the end of the year. That is, income is recognised
as earned - and the consequence is that profit or loss might arise from the
business earned on that year.
We carry forward unearned income into the next accounting period. The
premium element of this is called unearned premium and unearned premium
reserves and unexpired risk reserves are created.
For example, if an annual policy is written on 1 September 2013, then for the 2013
calendar year, the earned premium will be one-third of the premium (assuming uniform
risk over the policy year) and the other two-thirds of the premium will be carried
forward into the 2014 calendar year.
Profit is crystallised in the year the premium is earned the basis of all this is
the accrual principle. This is not a cash basis (where, if you have a two-year
policy, you earn half the premium in the first year and half in the next). Rather,
the income recognition is matched to the risk taken in each period. Out of this
flows the profit or loss made on the business.
Annual accounts have traditionally been referred to as one-year accounts. You may
also see them referred to as accident year accounts.
The term accident year refers to a grouping of claims according to the year in which the
loss event actually occurred, irrespective of when they are reported or paid, and the year
in which cover commenced.
Funded (or three-year) accounts were introduced in Chapter 8. They are typically used
for Lloyds, reinsurance and marine and aviation business.
Under funded accounting, we considered the business written in each year and
could not release profits until the end of three years.
Lloyds of London now also uses an annual accounting basis, but the legacy of
funded accounting remains in internal financial management as the underwriting
year accounting approach is consistent with the way Lloyds syndicates manage
capital.
It is also used by companies when we calculate the emerging profit and when we
calculate underwriting and reserve risk, which may be reduced to reflect
investment income that will be earned on assets held against reserves and on
premiums received in relation to the current and prior underwriting years.
The term underwriting year refers to a grouping of claims according to the year in
which cover commenced, irrespective of when the loss event occurred, and when the
claims are reported or paid.
The process of converting underwriting year results to accident year results is discussed
further in Section 0.
2 Annual accounting
2.1 Introduction
In the annual accounting model for insurance contracts, we need to consider the
following:
Outgo claims, claims handling expenses and other expenses paid and
changes in claims outstanding (including IBNR) in the accounting period,
reinsurance premiums, commissions, profit commissions, underwriting
charges / taxes
When policies are written the insurer pays commission and other initial
expenses. At the accounting date those acquisition costs have been paid out but
not wholly incurred for any policy that is unexpired at the time, just as part of
the premium received has not yet been earned. (You could think of them as
unincurred expenses, but the name DAC is universally used.) DAC is
usually a significant asset in the insurers accounts. It is like a negative reserve.
Decreasing DAC reduces the insurers profit, just as increasing reserves does.
Alternatively one can consider the building blocks as the premium (involves
income) and the risk assumed (reflected in a liability) the model is based on the
insurer being able to price the risk sufficiently well so that after paying the
claims / paying the admin and getting the return on the investment of the money
paid in premium, they will be able to make some profit.
The precise layout of the published accounts will vary depending on the accounting
rules in place.
The technical account (or revenue account) shows the basic trading profit from writing
insurance business for a given period. Note that strictly speaking, this terminology is
only needed for Subject SA3 (it has an asterisk in the Glossary).
In its most basic form, profit for a given year can be expressed as:
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There are a few other differences between UK GAAP and IFRS mainly because,
for instance, IFRS 4 permits a range of accounting policies from previous
regimes. Hence there is currently some divergence across the board from IFRS
reporters.
For instance:
Under UK GAAP, discounting is only permitted under very limited
circumstances for general insurers (ABI SORP requires a run-off period of
more than four years on average for the classes to be discounted).
The definition of acquisition costs to be discounted is also prescribed in
the ABI SORP, but in IFRS you could have a different definition if the
previous reporting regime was different.
This represents a fundamental change from the annual accounting model. The
International Accounting Standards Board (IASB) is liaising with the industry,
supervisors and national financial reporting authorities as it develops these
proposals. The timetable for implementation is subject to change, although
details of the current timetable can be found on the IASBs website.
Solvency II is discussed in Chapter 26, Regulation and also covered in Subject CA1
and Subject SA3.
The IFRS Phase II proposals are broadly in line with the proposals for measuring
insurance liabilities for Solvency II, although at a detailed level there are
significant differences. The detailed IFRS proposals are beyond the scope of
this course and will be subject to change up until a final standard is produced.
It is also worth saying that the current UK GAAP regime is also in the process of
being changed from 2015. In the particular case of insurance a new standard
for accounting for insurance under UK GAAP is currently being developed by the
Accounting Council and there is still a lot of debate surrounding this.
If you are interested in the IFRS proposals, you can find more information on the
International Accounting Standards Board website, www.iasb.org.uk.
This chapter and the Core Reading use the terms funded accounting and three-year
accounting interchangeably. However, it is important to remember that other
accounting periods (eg two or four years) are also used on a funded basis.
All the premiums for business written in 2011 are notionally kept in a separate fund and
all claims and expenses relating to this business are paid from this fund. We shall refer
to the amount in this fund at time X as Fund2011,X
At the end of the first year of trading (ie at the end of 2011), there is one fund of amount
Fund2011:31/12/2011
During 2012, a new fund is started which will hold all premiums and cover all claims
and expenses in respect of business written in 2012. Note that the 2011 fund will still
be maintained to account for premiums, claims and expenses relating to business written
in 2011. At the end of 2012 there will be two funds: Fund2011:31/12/2012 and
Fund2012:31/12/2012.
A third fund is opened on 1 January 2013 for business written in 2013. All the
premiums, claims and expenses for these policies are accounted for within the 2013
fund.
The convention with funded accounts is to close a fund at the end of its third year.
(Hence, three-year accounts.) So at 31 December 2013, the 2011 account will be
closed.
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This is not a component of current GAAP or IFRS. The proposal under Phase II
is to value liabilities at the discounted probability-weighted value of cash flows
plus:
a risk margin amount or margin reflecting an assessment of uncertainty
associated with insurance risk, and
a residual margin the expected profit or loss of a contract at outset,
excluding excess investment returns and risk margins.
Question 25.1
General insurers have historically not discounted their reserves. Do you think that this
practice has been consistent with the interpretation of prudence described above?
The reason for constructing the accounts will influence the size of margins that will be
included in the accounts. Accounts that are produced to demonstrate solvency are
likely to be prepared on a more cautious basis than those prepared for management,
which are produced to give a realistic picture of the profitability and financial strength
of the company.
In addition, the concept of prudence under IFRS Phase II is different from that
under UK GAAP, in that it does not allow the creation of hidden reserves or
excess provisions by the deliberate understatement of assets or income or the
deliberate overstatement of liabilities or expenses.
Under IFRS, an insurer need not change its accounting policies for insurance
contracts to eliminate excessive prudence. However, if an insurer already
measures its contracts with sufficient prudence, it shall not introduce additional
prudence. Introducing additional prudence would not make the accounts more
reliable or relevant and vice versa, and therefore the change would not be
allowed.
Other than as described in this chapter, candidates for Subject ST7 examinations
will not be expected to be familiar with the accounting concepts and principles
that apply in any particular country. They may, however, be expected to discuss
the problems that arise in defining such concepts and principles and putting
them into practice, and the implications for the interpretation of insurers
accounts.
2 Interpreting accounts
Before attempting to interpret the accounts of an insurer, we should become
familiar with the statutory rules governing the preparation of the accounts and
the accounting rules and conventions that apply in the country concerned.
This paragraph can be related back to the actuarial control cycle. Before we can
monitor the experience of an insurer, we should be familiar with the economic and
commercial environment in which the insurer operates.
We should consider the basis used for the valuation of the assets and the
treatment in the accounts of realised and unrealised capital gains and losses. If
assets are shown at market value, we should consider the vulnerability of the
asset values to changes in market conditions.
Lets consider Company A and Company B and for each company calculate the
solvency ratio, a useful measure of financial strength. The solvency ratio is defined as
free reserves divided by net written premiums.
Company A Company B
Total assets 740m 740m
Total liabilities 650m 615m
Net written premiums 500m 500m
Solvency ratio 18% 25%
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Company X Company Y
Total assets 260m 260m
Total liabilities 160m 200m
Net written premiums 300m 300m
Solvency ratio 33% 20%
Profitability
Different reserving bases can also distort the picture for profitability. However, it is
much less clear whether profit will be understated or overstated.
Question 25.3
Is it true that a company with a strong reserving basis will always show smaller profits
than an equivalent company with a weaker reserving basis?
Conclusion
The strength of the reserving basis can have a distorting influence on the apparent
financial strength and apparent profitability.
The extent to which this is feasible will depend on the amount of detail given in
the financial statements.
There are some useful disclosures that are normally present in any set of
accounts, such as:
triangles in the case of IFRS
fair value hierarchy of investments to check asset valuations and their
potential volatility
disclosures around reserves to work out reserve releases /
deterioration etc.
A sharp rise in premium income may be a sign of competitively low, and perhaps
unprofitable, premium rates. It may also affect the progression of other items
such as the ratio of the reserve for outstanding claims to the earned premiums,
the new business strain and the statutory minimum solvency margin.
In the next section we will look at the key values and ratios that might be considered
when analysing a general insurers accounts including the ratios mentioned above.
There are two implementation dates for Solvency II, one for regulatory authorities and
one for insurance companies.
Lamfalussy process
The new Solvency II framework has been created in accordance with the
Lamfalussy four-level process.
The Lamfalussy framework was drawn up by the Committe of Wise Men in 2001,
chaired by Baron Alexandre Lamfalussy.
EIOPA has provided technical advice and support to the European Commission
for the development of the implementing measures under Level 2, and is
responsible for producing the Level 3 additional guidance.
(a) Using the method of moments to fit a normal distribution to the data,
estimate the required pure premium for a stop loss layer 15% excess of
85% loss ratio for 2014.
(b) Estimate the required pure premium for a stop loss layer 20% excess of
100% loss ratio using a log-normal distribution.
Hint: You should use the expressions given following part (iv) below for the
limited expected value function. [6]
(iii) Draw a rough bar chart of the data and explain which distribution you would
choose for setting rates. [3]
(iv) It is suggested that rates on the business have deteriorated over the period.
(a) Discuss briefly whether the data suggest that this is true.
(b) Outline how you would allow in the calculation of the stop loss premium
for any such decline in rates. [4]
Note
For a random variable X with density function f(x) and distribution function F(x) the
limited expected value function E(X;x) can be expressed as:
The limited expected value E(X;x) for each distribution can be evaluated as follows:
Normal
x- m x- m x - m
E ( X ; x) = mF - sf + x 1 - F
s s s
Log-normal
s 2 log x - m - s 2 log x - m
E ( X ; x) = exp m + F + x 1 - F
2 s s
where F is the distribution function of the standard normal and f the density function
of the standard normal distribution with mean m and standard deviation s .
[Total 18]
2 Exam-style questions
Question 6.19
An insurance company that writes only motor insurance has a financial year running
from 1 January to 31 December.
On 1 May, a broker sold an annual policy with a premium of 450. The company
received the premium, net of 14% commission, on 15 June. No claims were made
under the policy. In addition to the commission, the marginal costs incurred from this
policy totalled 10 on acquisition and 1 at the start of each month thereafter, finishing
on 1 May one year later.
The company earned 1% per month on its assets in the first calendar year (ie from 1
May to 31 December), and 0.8% per month in the second year (ie 1 January to 30
April).
Assume that the company prepares its accounts on the basis of acquisition costs being
20% of written premium, and that IBNR is calculated on a very crude basis, namely as
5% of premiums earned in the year.
(i) Stating all further assumptions and ignoring the impact of taxation, show how
this individual policy will affect the companys accounts for each of the two
calendar years in question. [15]
(ii) Explain, in detail, how your answer would differ if the company decided at the
end of the first calendar year that for policies written during that year, the
premiums would be inadequate to cover the claims that would emerge from the
policies in future. [4]
[Total 19]
Question X1.8
You are the actuary with an insurer that has experience of writing motor insurance over
a number of years. The insurer is considering establishing a separate class for classic
motor vehicles (ie collectors items).
(i) By considering each risk factor, discuss how the risk arising from policies in this
class might differ to that arising from standard motor insurance. [7]
(ii) Describe how the companys approach to new business acquisition may have to
change. [3]
[Total 10]
Question X1.9
List the factors relating to the external environment that may affect claim frequencies or
amounts for motor insurance policies. [6]
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Solution X1.9
Comment
This question is testing your ability to apply the ideas in Chapter 7, External
environment.
Claim frequencies
Claim amounts
Solution X2.3
Comment
This question is testing Chapter 9, Modelling uncertainty. You should consider all the
components of an insurers return, eg premiums, claims, expenses etc.
Premiums could be too high, leading to lower than expected volumes of business and a
failure to adequately cover fixed expenses. []
Low investment income, falls in assets values or increased taxation of returns. [1]
Other possibilities:
adverse currency movements
failure of third parties, eg reinsurers
changes in legislation
mis-management of the syndicate. [ each, total 1]
[Maximum 6]
This is the uncertainty that arises when choosing the parameters for the model. []
It is a result of the statistical variability in the past data used as a starting point for
setting the parameters []
for example due to the presence in the past data of an unusually large claim. []
This is the uncertainty that arises because of the inherent randomness of the process
being modelled. []
Solution X4.4
Comment
... however this only allows for very simple dependencies between classes. []
For example, the Gumbel copula and the t-copula allow for increased correlations in the
tails of the distribution. []
Solution X4.5
Comment
The Core Reading for this question is covered in Chapter 16, Reserving use of ranges
and best estimates.
The key points to consider when communicating a best estimate reserve are:
Who the recipients are, their level of knowledge and how they will use the
information. [1]
How we get across that the best estimate is just an estimate []
that there are other possible reasonable estimates []
that the actual result is likely to be different from the best estimate. []
How we clarify that the best estimate is just the mean of the distribution ... []
it will not necessarily reflect the most likely outcome []
particularly if the distribution is positively skewed. []
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Question X6.1
A general insurance company has been selling steady volumes of business for many
years. The company has the following reinsurance treaties in place:
A quota share arrangement under which 60% of the business is ceded. The
reinsurer pays the insurance company an override commission of 7% of the
reinsurance premium.
A 10-line surplus treaty, with a maximum retention limit of 1m.
An excess of loss treaty that pays 90% of all losses above 0.5m, the premium
for which is calculated as 3% of the insurers gross written premium.
(i) Give a formula that, for a surplus treaty, relates the expected maximum loss
(EML) to the retention (r) and number of lines (l). [1]
(ii) A company director has written asking if you can give him an indication of the
maximum amount that the company would have to pay out as a result of an
individual claim. Set out the points that you would make in reply. [4]
(iii) Comment on the suggestion: The quota share treaty is better than the excess of
loss treaty since the quota share treaty pays commission whilst the excess of loss
treaty costs the insurer. This must also mean that the excess of loss reinsurer is
making more profit than the quota share reinsurer. [5]
[Total 10]
Question X6.2
(iii) List the capital requirements that an insurance supervisor might impose on an
insurer. [3]
(iv) Describe the disadvantages to insurers of complying with the IAIS Core
Principles (ICPs). [3]
[Total 10]
Question X6.3
A general insurance company, which writes only direct business, accounts for all its
business on an accident-year basis.
Comparison of the companys solvency margin (excess of assets over liabilities) with
the solvency margin for other direct insurers shows that the companys solvency margin
has fallen, whereas the margin for most other companies has risen.
Explain the extent to which comparison of the solvency margin of different insurance
companies can validly be made, and describe the factors that would need to be taken
into account if the purpose of the comparison were to establish the likelihood of future
insolvency. [14]
Question X6.4
You are a consultant actuary. One of your clients is considering the purchase of a
general insurer that only sells motor business. Initially, you have been given two years
accounts for the insurer, which are as follows:
Assignment X6 Solutions
Solution X6.1
Comment
This question tests your understanding of the material in Chapter 22, Determining
appropriate reinsurance, as well as building on your understanding of Surplus
reinsurance, from Chapter 5, Reinsurance products (2).
(i) Formula
There is no maximum amount that the company could lose. Theoretically, losses are
infinite. []
For anything above 0.5m, (net of quota share and surplus) the insurer only pays 10% of
the excess. There is reduced, but still unlimited, liability above this cut off point. []
The size of the original, gross of reinsurance claim that would result in a net (of quota
share and surplus) claim of 0.5m is dependent upon whether the surplus treaty is used
and the number of lines used. []
A gross claim as small as 1.25m would result in a net claim of 0.5m if no surplus
lines were used, but a claim as high as 13.75m could also result in a net claim of 0.5m
if the full 10 lines were used. [1]
Although the maximum retention under the surplus treaty gives no guaranteed
maximum that we reasonably expect to lose, it does give a reasonable indication. []
In this case the maximum is 1m, net of the quota share treaty. []
If a claim for this maximum of 1m did come in the insurer would pay 0.55m. []
All of these figures assume that the reinsurers stay solvent. If any of the three reinsurers
default, the amount could rise sharply. []
[Maximum 4]
but only to reimburse the insurer for the costs associated with setting up and
servicing the reinsured policies (eg underwriting, pricing, new business administration).
[]
So the benefit of the commission is only to compensate for costs that the insurer has
incurred. []
With excess of loss the insurer keeps all the profit that is loaded into its premium rates.
[]
When deciding which is best we must think about the benefits of reinsurance not
just the costs. []
There could be other benefits, eg technical assistance, although this is more likely to
come from the broker rather than the reinsurer. []
The key benefit of excess of loss is to protect the companys solvency (and stability of
profits) against large claims. []
Quota share would not be so effective in this respect so how can you say that it is
better? []
It is impossible to say which reinsurer is making the most profit. We should look at a
risk-adjusted profit. The excess of loss reinsurer may be taking more risk. [1]
[Maximum 5]
Solution X6.2
Comment
Key objectives of regulation and supervision are to promote efficient, fair, safe and
stable insurance markets and to benefit and protect policyholders. [1]
The IAIS:
issues global principles, standards and guidance papers []
provides training and support on issues related to insurance supervision, and []
organises meetings and seminars for insurance supervisors. []
[Maximum 1]
Disadvantages include:
valuations may be less prudent, eg where the regulation requires assumptions to
be based on actual experience, without including margins []
a risk-based approach could increase the volatility of results, leading to: []
more volatile distribution of profits []
reduce the availability of capital []
broader reporting requirements may mean that intra-group arrangements will
have to be disclosed []
this may bring further disadvantages, eg tax implications for
arrangements that take place across different territories []
increased costs of regulatory supervision, which may be passed onto insurers via
increased levies []
increased costs of compliance []
loss of market confidence if insurers are seen not to comply with recognised best
practice. []
[Total 3]
Solution X6.3
Comment
The Core Reading for this question is covered in Chapter 25, Interpreting accounts.
Comparison can validly be made between the solvency margins of two companies, but
there are many factors that will distort this comparison. These factors should be taken
into account where possible, ie comparison can only be made to a limited extent. [1]
In the text below, less risk implies that there is a lower likelihood of insolvency.
Size of margin
Diversification
Asset values
If assets are valued on a mark-to-market basis, then a company with a bigger proportion
of assets that are temporarily undervalued by the market might be less risky than would
appear from the published returns. [1]
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