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FORMAL EXAMINATION PERIOD: SESSION 2, NOVEMBER 2016

Unit Code: ACST403 & ACST732 & ACST832

Unit Name: Actuarial Control Cycle 2

Duration of Exam 3 hours plus 10 minutes reading time


(including reading time if applicable):

Total No. of Questions: 8


Total No. of Pages 7
(including this cover sheet):

GENERAL INSTRUCTIONS TO STUDENTS:


Students are required to follow directions given by the Final Examination Supervisor and must refrain from communicating in any way with another student once they have entered
the final examination venue.
Students may not write or mark the exam materials in any way during reading time.
Students may only access authorised materials during this examination. A list of authorised material is available on this cover sheet.
All watches must be removed and placed at the top of the exam desk and must remain there for the duration of the exam. All alarms, notifications and alerts must be switched off.
Students are not permitted to leave a final examination venue during the last 15 minutes of the examination.
If it is alleged you have breached these rules at any time during the examination, the matter may be reported to a University Discipline Committee for determination.

EXAMINATION INSTRUCTIONS:

Please answer every question.

The number of marks allocated for each question is shown in brackets [ ] at the start of the
question. The number of marks for each sub-question is shown in brackets [ ] at the end of the sub-
question. The total number of marks is 100.

You have been supplied with 8 answer booklets. Please write your name and student id number on
each booklet. Label the booklets as Q1, Q2, Q3, Q4, Q5, Q6, Q7, and Q8. Answer each question in a
separate booklet.

Please write your name and student id number on this paper and hand it in (along with your
answer booklets) at the end of the examination.

This examination is being held in a number of locations internationally and it is inevitable that there will
be differences in the timing of up to several hours. You are absolutely prohibited from doing anything
that may lead to other students gaining information about this examination paper before sitting for the
examination. Any breaches (either disclosing information or receiving information) will be viewed as
professional misconduct as well as an infringement of University rules and will be dealt with accordingly.

AIDS AND MATERIALS PERMITTED/NOT PERMITTED:


Dictionaries: No dictionaries permitted
Calculators: Non-programmable calculators which do not have a text retrieval capacity are permitted
Other: Closed book No notes or textbooks permitted
Question 1 [15 marks]

You are a member of the actuarial department of a small general insurance company. It is the end
of the financial year and you have been asked to prepare data for the annual valuation of
outstanding claims.

(a) The valuation process relies on case estimates. The case estimates for each policy are held
on the policy claims data base. What would you do to check the accuracy and reliability of
the case estimates? [5 marks]

(b) The actuary will value outstanding claims gross and net of reinsurance. While you are
preparing the paperwork about reinsurance agreements, you find that the file contains a
side letter labelled Highly Confidential, which indicates that one of the reinsurance
agreements might be a financial reinsurance arrangement. What is financial reinsurance?
What are the Australian prudential regulations which are relevant to such arrangements?
[5 marks]

(c) When you ask your boss about this side letter, he tells you that this letter was left in the file
by mistake, and you should forget you ever saw it. What should you do? Refer to any
aspects of the Code of Conduct which are relevant to your decision. [5 marks]

Question 2 [9 marks]

(a) In the context of the published financial statements of Australian general insurance and life
insurance companies, explain the meaning of Deferred Acquisition Cost (DAC).
[3 marks]

(b) For a fast-growing general insurance company, how does the DAC affect the assets,
liabilities, and recognition of profits as shown in the financial statements?
[3 marks]

(c) How do you think DAC should be treated when calculating the regulatory capital of a
general insurance company? Give reasons for your answer.
[3 marks]

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Question 3 [18 marks]

The ABC Superannuation Fund is an Australian multi-employer defined contribution fund (i.e. a
defined contribution fund where many employers contribute to the same fund).

Employers must contribute 9.5% of salaries and wages into any fund chosen by their employees;
fund members can make additional voluntary contributions into their own accounts if they wish to
do so (subject to regulatory limits).

Members have a choice of several different investment options, including the Balanced Fund, the
Fixed Interest Fund, the Listed Shares Fund, the Property Fund, the Private Equity Fund, the
Venture Capital Fund, and the Hedge Funds Fund. The default fund is Balanced (i.e. a mix of cash,
government bonds, shares, and property). Members can switch options at any time. The
investment returns are credited using a unit pricing system.

Retired members can leave their account balance at ABC, or withdraw their money at any time.

(a) The trustees have never before felt the need to have a liquidity management plan, because
the funds cash flow has always been positive.

(i) Explain how this superannuation fund might be exposed to liquidity risk. [It might
be helpful to recall some of the problems which arose during the Global Financial
Crisis] [3 marks]

(ii) What steps should the trustees take to manage liquidity risk? [7 marks]

(iii) One of the trustees has suggested that in an emergency, the Balanced Fund can be
used to provide liquidity to other Funds. Explain how this would work and comment
on this proposal. [3 marks]

(b) Unit prices reflect the investment returns for each investment option.

(i) The trustees have always calculated daily unit prices based on the market value at the
end of the previous day (historic pricing). They are considering switching to use
forward pricing, based on the market value at the end of the current day. State one
advantage and one disadvantage of historic pricing.
[2 marks]

(ii) One of the trustees says: The Unit Price is just the Value of Assets divided by the Number
of Units how hard can it be? Briefly describe three areas of difficulty in correctly
determining daily unit prices.
[3 marks]

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Question 4 [10 marks]

Banks are required to hold capital to cover market risks. Many banks use Value-at-Risk (VaR)
models to quantify their market risk exposures and to determine regulatory minimum capital
requirements.

(a) Explain how VaR models work and how you would obtain the relevant data for such a
model. [4 marks]

(b) What do you think are the main advantages and disadvantages in using VaR models for this
purpose? [4 marks]

(c) How would you respond if the bank operates in a country where risk-free interest rates
have just become negative at all durations on the yield curve?
[2 marks]

Question 5 [9 marks]

Reinsurance agreements made between a direct insurance company and a reinsurance company
often include a profit sharing clause. If claims for the year are lower than expected the reinsurer
pays a share of this profit to the direct insurer. If claims are higher than expected, the reinsurer
pays all the claims.

(a) What do you think are the advantages of such an arrangement to the reinsurer?
[4 marks]

(b) For a particular reinsurance treaty there is an 80% chance that the reinsurers share of
claims will be 100 and a 20% chance they will be 200. So the expected claims are 120
(before reinsurance expense and profit margins). What additional premium should the
reinsurer charge in order to provide a profit share to the direct company of 50% of claims
profit, where claims profit is defined as the excess, if any, of premiums over claims? Ignore
expense loadings and profit margins.
[3 marks]

(c) Do you think such profit sharing arrangements are more practical for short tail classes of
business or long tail classes? Explain your reasoning. [2 marks]

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Question 6 [14 marks]

The Golden Oldies Charity operates a retirement village which provides accommodation for up to
100 residents. Any woman aged 75 or over can buy a life tenancy in one of the retirement village
units that is, she can pay $X in a lump sum, and then she can live in the unit for the rest of her life
at no further cost. Whenever any resident dies, her unit becomes vacant, and the Golden Oldies
Charity immediately sells a new life tenancy to a new resident.

The charity is responsible for paying the all the expenses of running the retirement village. This
includes rental costs and property maintenance, plus the cost of providing specified services to the
residents.

As at 1 January 2017, the charity held assets of $8,000,000. There are 100 residents who are all
females aged 75.

You have been asked to do a projection to estimate the surplus at 1 January 2018. The surplus is
defined as the excess of assets over the liabilities.

You have used the following assumptions:

The expected investment return is 5% per annum.


The expected expenses will be $8,200 per person per annum in 2017. For simplicity we
assume that the expenses are all paid at mid-year.
Three women will die in 2017. For simplicity we assume that deaths will occur at mid-
year on average.
Each woman who dies will immediately be replaced by a woman of the same age as the
deceased woman.
Any new residents will pay an entry fee of $90,000, payable as soon as they move into
their new unit, i.e. immediately after the death of the former tenant.
The liabilities of the charity are calculated as the present value of the expected future
expenses for all residents who are in residence as at the valuation date. The actuary has
advised that the expected value of the liabilities at the end of the year will be

8,200 * 100 * 76 , where the annuity value 76 = 8.

This annuity value has been calculated using suitable mortality, inflation, and interest
rate assumptions.

(a) Verify that the expected surplus on 1 January 2018 is $1,276,418. [2 marks]

This question continues on the next page.

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(b) Recalculate the surplus allowing for actual experience, which is:

Investment returns of 4% per annum,


Expenses of $8,500 per person,
There were 5 deaths during the year.
[2 marks]

(c) Analyse the difference between the actual and expected surplus (or deficiency) into an
investment component, an expense component, and a mortality component, in that order.
Apply checks to your answer. [8 marks]

(d) How would your answer to part (c) change if the actuary revised his valuation assumptions
at the end of period, so that 76 = 9?
[2 marks]

Question 7 [12 marks]


Australian life insurers sell Total and Permanent Disability (TPD) products, which provide lump
sum benefits to people who become totally and permanently disabled. TPD cover is sold to
individuals and is also sold on a group basis. Group policies are sold to superannuation funds and
cover any fund members who chose this benefit option.

A few years ago, some Australian life insurers were suffering significant losses on their TPD
business. As a result of the losses, some insurers decided to change their claims management
systems to tighten claim approvals.

Recently, television and newspaper stories have criticised the life insurers for unfairly rejecting
claims which seem to be quite valid. The reputation of the industry has suffered.

Suppose that you have been asked to help a life insurer ensure that its claims management process
is fair, while also ensuring the profitability of the business.

As a student of the Control Cycle, you understand that decisions made about claims management
will be affected by, and will affect, decisions made about other aspects of the business. Therefore
claims management should be considered in the broader context of managing the business.

Keeping this in mind, set out your strategy for helping this insurer to achieve its objectives.

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Question 8 [13 marks]

You are the appointed actuary of a recently established life insurance company listed on the
national securities exchange. The company sells term life policies through a network of financial
planners who receive commissions of 115% of the annual premium in the first year and 10% each
year the policy is renewed. The company reports on the Margin on Services accounting method.

Each year you assist in the preparation of a three year business plan which includes a detailed
budget for the next twelve months.

Six months into the current year it is apparent that new business has been higher than expected
and sales expenses have increased in line with the increased sales. Short term profitability will be
depressed because not all of the new business expenses can be deferred and amortised. Also the
higher than expected growth will require more capital than expected. Otherwise the business is
tracking in line with expectations.

The experience was discussed at a recent Board meeting and directors were clearly unhappy at the
prospect of raising more capital (or reducing dividends) at a time when profits are not meeting
expectations. After the Board meeting, a director met with you and asked the following questions:

(a) Why do we incur the expense of a three year business plan when we cant possibly forecast
where we will be in three years time? [3 marks]

(b) Can we just reduce initial commissions to planners to improve profits and slow growth so
we dont need more capital? [3 marks]

(c) Alternatively, can we increase premium rates which should have the same effect?
[3 marks]

(d) Can you suggest two other possibilities we should investigate to reduce our need to raise
more capital this year? What disadvantages do you see with each possibility?
[4 marks]

END OF EXAMINATION