Practice questions on Analysis of Surplus / Analysis of Profit (with solutions)

From old exam papers

2000 Exam Question 1 Superannuation Fund Pensioners

2006 Exam Question 6 Annuities

2000 Exam Question 1 [18 marks]
An Australian superannuation fund has been closed to new entrants for many years and now
has only members in receipt of a pension. Through a remarkable coincidence, all the
pensioners are the same age and sex and each one receives the same amount of pension.
Pensions are non-commutable, and are payable annually on 30th June each year as long as the
member lives. The amount of the pension is indexed in line with the Consumer Price Index.
The adjustment is calculated twice a year: once just before the payment on 30th June, and
once before valuing the liabilities, which are valued every year on 31st December.

The results of the valuation on 31st December 1998 were as follows:

No of members 300
Amount of pension pa
(including indexation up to 31st December 1998) $9,300,000
Liabilities $82,404,000
Assets $82,404,000

The assumptions made in the valuation were:

(a) Investment income would be earned at the rate of 7% pa, and pro rata for
fractions of a year (ie assume simple interest for periods of less than a year)

(b) Inflation as measured by the Consumer Price Index would be 3% pa, and
pro rata for fractions of a year

(c) Expenses would be 1% of pensions paid, incurred at the time of payment

(d) There would be 12 deaths in 1999, occurring evenly throughout the year.

[2] (i) Show that if the expected surplus for 1999 is zero, the expected liabilities
at the end of the year are $78,502,050

[16] (ii) The experience during 1999 was as follows:

(a) Total investment income was $6, 571,000

(b) The CPI rose 2% in the first six months of the year, and a further 2.1% in
the second six months, giving a total increase for the year of 4.142%

(c) Expenses, expressed as a percentage of pensions paid, were 1% of

pensions, exactly as expected

(d) There were 10 deaths in 1999, of which 7 occurred in the first six months
of the year
 At the end of the year the assets were 79,617,693 and the liabilities, on the
same basis as before, were 79,923,629

Analyse the experience profit into the contributions from interest, inflation and
mortality, in that order.

2000 Exam Solution for Question 1

(i) The assets at the end of the year will be

Assets now plus interest for the full year

less pensions (with expenses) paid to those who are alive at mid year
accumulated with half a year's interest

= 82,404,000 * 1.07 - (300-6) * (9,300,000/300) * 1.015 * 1.01 * 1.035

= $78,502,050

If there is no surplus then the PV of liabilities must equal the PV of assets, i.e.
PV of liabilities = $78,502.050

(ii) Total surplus = Assets at year end - PV Liabilities at year end

= 79,617,693 - 79,923,629

= -305,936 i.e. a deficit

Check assets = 82404000 + 6571000 - Pensions paid - Expenses

pensions paid = (300 - 7) * (9300000/300) * 1.02

= 9,264,600

expenses = 1% of pensions = 92646

assets = 79,617,693

Check liabilities = PV of $1 per survivor * number of survivors

* amount per person

PV of $1 p.a. per survivor

= 78502000 / [(300-12) * (9300000/300)*1.03]

= 8.536692

Number of survivors = 300 - 10 = 290

Amount payable = (9300000 / 300) * 1.02 * 1.021 = 32284.02

PV liabilities at year end = 290 * 32284.02 * 8.536692 = 79923629.40

Surplus = S(i,i2, d1,d2, f1,f)
= A0 * (1+i) - (300-d1) * 31000 * (1+f1) * 1.01 * (1+i2)

- (300-d1-d2) * 31000 * (1+f) * 8.536692

where i = interest rate for whole year

i2 = interest rate in second part of the year
f = inflation rate for the whole year
f1 = inflation rate for the first half
d1 = deaths in first half
d2 = deaths in second half
and with a dash indicates actual experience
and with no dash indicates expected experience

Interest surplus = Actual interest - expected interest based on actual cash flows
= S(i', i2', d1', d2', f', f1') - S(i, i2, d1', d2', f', f1')
= 6571000 - [0.07 * 82404000 - .035 * (300-7) * 31000 * 1.02 *1.01]
= $1,130,225.73

Inflation surplus = S(i,i2,d1',d2',f1',f') - S(i,i2,d1', d2', f1,f)

= - 293 * 31000 * 1.02 * 1.01 * 1.035 - 290 * 31000 * 1.04142 * 8.536692
+ 293 * 31000 * 1.015 * 1.01 * 1.035 + 290 * 31000 * 1.03 * 8.536692

= - 293 * 31000 * (.005) * 1.01 * 1.035 - 290 * 31000 * (0.01142) * 8.536692

= -923900.88

Check : inflation was higher than expected, which causes an increase in the payments
and in the end of year liabilities, leading to a deficiency

Mortality surplus = S(i,i2,d1',d2',f1,f) - S(i,i2,d1, d2, f1,f)

= - 293 * 31000 * 1.015 * 1.01 * 1.035 - 290 * 31000 * 1.03 * 8.536692

+ 294 * 31000 * 1.015 * 1.01 * 1.035 + 288 * 31000 * 1.03 * 8.536692

= 1 * 31000 * 1.015 * 1.01 * 1.035 - 2 * 31000 * 1.03 * 8.536692

= -512,261.12

Total surplus = 1,130, 225.73 -923,900.88 - 512,261.12 = -305.936.37

which is the correct total

2006 Exam Question 6 [12 marks]
You are asked to analyse the experience of an annuity fund consisting of lifetime annuities
written by your company several years ago. At 1 January 2004 there were exactly 100
annuities remaining in force. The annuitants were then all 63 year old males, and each one
had annuity payments of $10,000 per year. Annuity payments are made each 31 December,
are increased each year with inflation, and cease on the death of the annuitant.

You are asked to analyse the experience of this portfolio over the 2 year period to 31
December 2005.

The liabilities at 1 January 2004 were calculated on a set of assumptions (the old basis).
The assumptions on the old basis are:

Investment earnings 8% pa
Inflation of annuity payments 4% pa
3 deaths in each calendar year 2004 and 2005

On these assumptions the present value of an annuity of $1 pa at 1 January is

11.394 for a 63 year old male, and
11.000 for a 65 year old male.

On this basis the liability at 1 January 2004 is 100 x $10,000 x 11.394 which is $11,394,000.

The company held $12,000,000 of assets in the annuity fund at 1 January 2004 to provide a
margin for safety.

(a) Show that on the old basis assumptions the initial liability of $11,394,000 should
be just sufficient to meet the annuity payments over the two years and set up the
liability at the end of that period. [3 marks]

Actual experience for the two year period was:

Investment earnings 7% pa
Inflation of annuity payments 3% pa
2 deaths in each calendar year 2004 and 2005

(b) Allowing for the initial assets of $12 million, show that the expected surplus at 31
December 2005 on the old basis is $706,848. [1 mark]

When you review the past experience of the portfolio and other industry statistics you decide
that your assumptions (old basis) are no longer realistic and need to be strengthened. On the
new basis the value of an annuity of $1 pa at 1 January is 11.25 for a 65 year old male.

(c) Calculate the actual surplus (or deficiency) at 31 December 2005 after allowing
for setting up the liability on the new basis. [1 mark]

(d) Analyse this actual surplus (or deficiency) into the components of change of basis,
investment earnings, inflation and mortality in that order. [7 marks]
2006 Exam Question 6 -ANALYSIS OF SURPLUS Model Answer

(a) Start by working out a formula for calculating surplus

Surplus = V0 * (1+I)^2 A * (100 D1) * (1+f) * (1+I)

- A * 12 * (100 D1 D2) * (1+f)^2

= 11,394,000 * 1.08^2 10,000 * 97 * 1.08 * 1.04

- 10,000 * 12 * 94 * 1.04^2

= 9.60 (close to nil)

(b) Use the formula to calculate expected surplus (based on expected experience for
investment income, inflation, and deaths) and actual surplus (based on actual experience for
investment income, inflation, and deaths)

Expected Surplus
= A0 * (1+I)^2 A * (100 D1) * (1+f) * (1+I)
- A * 12.25 * (100 D1 D2) * (1+f)^2

= 12,000,000 * 1.08^2 10,000 * 97 * 1.08 * 1.04

- 10,000 * 12 * 94 * 1.04^2

= 706,848

Actual Surplus
= A0 * (1+I)^2 A * (100 D1) * (1+f) * (1+I)
- A * 12.25 * (100 D1 D2) * (1+f)^2

= 12,000,000 * 1.07^2 10,000 * 98 * 1.07 * 1.03

- 10,000 * 12.25 * 96 * 1.03^2

= 182,558

Deficiency
= 706,848 182,558

= 524,290

(c) Part of the difference between expected and actual surplus is caused by aa change in the
valuation basis at time t = 2. We want to analyse the surplus assuming that there had not been
any change in basis. Then the surplus caused by the change in basis is considered to be aa
separate item in the analysis.

Step 1 Isolate change of basis

Actual Surplus on old basis

= 12,000,000 * 1.07^2 10,000 * 98 * 1.07 * 1.03
- 10,000 * 12 * 96 * 1.03^2
 = 437,174

Deficiency on old basis = 706,848 437,174

= 269,674

Therefore the impact of the change of basis = 269,674 - 524,290

= - 254,616

Step 2 is a normal analysis on the old basis

Expected surplus = f ( i , f , d )

Actual surplus = f ( i' , f' , d' )

Splitting into different components of experience = f ( i' , f' , d' ) - f ( i , f , d )

= f ( i' , f' , d') - f ( i , f' , d' ) interest surplus

+ f ( i , f ', d' ) - f ( i , f , d' ) inflation surplus

+ f ( i , f , d' ) - f ( i , f , d ) mortality surplus

Interest surplus = 12,000,000 * (1.07^2 1.08^2)

- 10,000,* 98 * 1.03 * (1.07 1.08)

= -247,906

Inflation surplus = - 10,000 * 98 * 1.08 * (1.03 -1.04)

- 10,000 * 12 * 96 * (1.03^2 1.04^2)

= 249,048

Mortality Surplus =

- 10,000 * 1.04 * 1.08 * (98 - 97)

- 10,000 * 1.04^2 * 12 * (96 - 94)

= -270,816

Check: for each item of experience, determine whether the sign is as expected. For example,
if investment experience is better than expected, the investment experience item should be
positive. If inflation is higher than expected, the inflation experience component should be
negative.

Check: Make sure that all components, when added together, match the difference between
actual and expected surplus.
- 254,616 247,906 + 249,048 270,816 = - 524,290 OK
Note that some students analysed the surplus using a different order of analysis, and hence
the answers were different. We allowed for these variations in the model solution.