Understanding

Risk
Management
Table of Contents
Applying Risk Management ............................................................................... 7

1. Identify risk.............................................................................................. 8
A. Insurer risk ..........................................................................................................................................8
B. Superannuation risk ..........................................................................................................................11
C. Fund management risk ..................................................................................................................... 12
D. Banking risk ...................................................................................................................................... 12

2. Risk assessment ...................................................................................... 13

3. Risk treatment ........................................................................................ 14

Product design ...................................................................................................... 16

Stage 1 Identify the need of a new (or modified) product ............................... 16

Stage 2 Develop a product strategy .................................................................. 17

Stage 3 Develop a product ................................................................................. 17

1. Project management ......................................................................................................................... 17
2. Design features to control risks........................................................................................................ 17
3. Competition, marketplace, and pricing process .............................................................................. 17
4. Stakeholder expectation ................................................................................................................... 18
5. Decision to launch the product or not ............................................................................................. 18

Stage 4 Manufacture and design the product .................................................. 18

Distributing the product to the client ....................................................................................................... 18
Risk selection.............................................................................................................................................. 18
Administration of the product................................................................................................................... 19
ALM ............................................................................................................................................................ 19

Stage 5 Gathering and monitoring experience ........................................................ 19

The Need for Capital ........................................................................................... 20

Type of capital ................................................................................................... 20

The reason for capital ....................................................................................... 20

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 The need for capital: perspective of different stakeholder ............................. 21

Financial institution without shareholders ......................................................22

Mutual organizations ................................................................................................................................. 22
Superannuation fund ................................................................................................................................. 22

Risk and capital needs in financial institution ................................................23

Asset risks ................................................................................................................................................... 23
Liability risks .............................................................................................................................................. 23
Asset/liability risks .................................................................................................................................... 23
Operational risk .........................................................................................................................................24

An overall company perspective ...................................................................... 24

Diversification benefits ..............................................................................................................................24
Economic vs regulatory capital .................................................................................................................24
Target surplus ............................................................................................................................................24
Capital allocation ....................................................................................................................................... 25

Modelling and Data ............................................................................................ 26

Using a fitted model ...................................................................................................................................26
Challenge the fitted model .........................................................................................................................26

Normative approach to modelling.................................................................... 27

Limitation of the normative approach ............................................................ 28

Commercial modelling ...................................................................................... 28

Data ........................................................................................................................... 28

Reason why we need data ................................................................................ 29

Sources of data .................................................................................................. 29

Assumptions ............................................................................................................. 30
Identification of assumptions................................................................................................................... 30
Quantifying assumptions .......................................................................................................................... 30

Pricing ...................................................................................................................... 31

Pricing process: application of the actuarial control cycle ............................ 31

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 Pricing objective: ................................................................................................ 31

Stakeholders: ...................................................................................................... 31

Description of each pricing process ..................................................................32

Pricing for long-term commitment ...................................................................33

Method of developing long term commitment solution: ......................................................................... 33

Other application ...............................................................................................34

Valuing Liability .................................................................................................. 35

Typical types of liabilities found in companys balance sheet ........................ 35

Measuring liabilities .......................................................................................... 35

Profit and the liability valuation....................................................................... 37

Practical valuation issues .................................................................................. 37

Financial economics and discount rates ......................................................... 38

Assets ........................................................................................................................39

Type of asset .......................................................................................................39

Valuing Asset ..................................................................................................... 40

Asset risk ............................................................................................................. 41

Asset-liability management .............................................................................. 41

Asset-liability management constraints ......................................................... 42

Solvency ..................................................................................................................43

Cash flow solvency .............................................................................................43

Discontinuance solvency and going-concern solvency: general approach . 44

Alternative form of discontinuance ..........................................................................................................44
Measuring discontinuance solvency .........................................................................................................44
Valuation of assets for solvency purposes ................................................................................................44

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 Valuation of liabilities for solvency purposes ........................................................................................... 45

Profit ........................................................................................................................ 46

Overview of Profit ............................................................................................. 46

Reported versus distributable profit ............................................................... 46

The traditional view of profit .....................................................................................................................46
The modern view of profit .........................................................................................................................46
Profit measurement versus solvency ........................................................................................................46

The emergence of profit ..................................................................................... 47

Sources of profit ......................................................................................................................................... 47
Timing of profit recognition ...................................................................................................................... 47

Emerging costs .................................................................................................. 48

Funding methods ...................................................................................................................................... 48

Appraisal values ................................................................................................ 49

Components of an appraisal value ............................................................................................................49
AV as a profit measure ...............................................................................................................................50

Monitoring Experience ....................................................................................... 51

Why do we analyse experience? ........................................................................ 51

What do we analyse? .........................................................................................52

General Insurance ...................................................................................................................................... 52
Life Insurance............................................................................................................................................. 52
Funds Management ................................................................................................................................... 52
Superannuation .......................................................................................................................................... 52
Banking ....................................................................................................................................................... 53
Health Insurance........................................................................................................................................ 53

How do we analyse experience? .......................................................................54

Demographic .............................................................................................................................................. 54
Economic .................................................................................................................................................... 54
Expenses ..................................................................................................................................................... 54
Business volumes ....................................................................................................................................... 55

Data issues ..........................................................................................................56

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Responding to Experience ................................................................................. 57

Role of the actuary ............................................................................................. 57

General considerations ...................................................................................... 57

Managing the business ...................................................................................... 57

Business plans ............................................................................................................................................ 57
Financial control systems .......................................................................................................................... 57
Audit systems .............................................................................................................................................58
Expense management ................................................................................................................................58
Capital management ..................................................................................................................................58

Allocating interest to accounts ..........................................................................59

Unit pricing .........................................................................................................59

Review of insurance pricing ............................................................................. 60

Review of experience ................................................................................................................................ 60
Pricing changes ......................................................................................................................................... 60
Competition ............................................................................................................................................... 60
Pricing responses ...................................................................................................................................... 60

Defined benefit superannuation........................................................................ 61

The actuarial review ................................................................................................................................... 61
The pace of funding.................................................................................................................................... 61
Responses to the actuarial review ............................................................................................................. 61

Recognising profit in insurance ....................................................................... 62

Recognising profit ......................................................................................................................................62
Life insurance: margin on services ...........................................................................................................62
General insurance: prudential margins ....................................................................................................62
Capital and distribution of profit ..............................................................................................................62

Participating life insurance ...............................................................................63

The origins of the actuarial profession ..................................................................................................... 63
Participating policies ................................................................................................................................. 63
Allocation and distribution of profit ......................................................................................................... 63
Allocation to profit ..................................................................................................................................... 63
Fair and equitable ...................................................................................................................................... 63
Distribution of profits ................................................................................................................................64

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Table of contents
Methods of distributions ...........................................................................................................................64
Asset share methods ..................................................................................................................................64

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Applying Risk Management

Process of Risk Management:

Envision
process

control risk identify risk

communicate

plan
assess risk
strategies

Generally, risk in enterprise divided by:

Business risk: those which are directly related to product sold by the company
Non-business risk: not directly related to the product sold. Related to running the business in
general. Include event risk and financial risk.

product risk
business risk macroeconomic risk
technological risk

legal risk
entrprise-wide
risk reputational risk
event risk
disaster risk
regulatory risk

non-
business market risk
risk
credit loss
liquidity risk

financial risk

operational risk
foreign exchange

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Risk management process
Following will describe in detail each step of risk management process

1. Identify risk
objective methodology Deliverable
Brainstorm
Focus group discussion
Identify and Statement of
Interview
prioritize key risk prioritized risk
Periodic risk reporting
Surveys

Before we can manage risk, we must identify them. At this stage of process we must also
prioritize the risk. It is also important to note that risk mitigation techniques are used to
manage risk. However is many case, risk mitigation is not simply remove the risk.

Identification and prioritize of risk begins with the gathering of information from individual
employees/team member of their concern, uncertainties or issue regarding the entity or process
under review. These review should be supplemented with feedback from relevant stakeholder.

A unique risk identifier should be assigned to each risk along with a clear statement of risk that
describes:

The circumstances causing uncertainty

tangible outcome of that uncertainty
any risk dependencies within entity or process

A. Insurer risk
Identifying insurer risk
Major of
Sub risks:
insurance risk
Included in product risk (in enterprise risk classification). The risk generally
fall into underwriting risk:
underwriting process risk: related to selection and approval
pricing risk: price charged is actually inadequate to support future
obligation
product design risk: risk which not anticipated in the product design
or insurance contract
underwriting risk claim risk (for each peril): many more claim occur than expected
economic environment risk: environment will change has an adverse
effect to the company
net retention risk: higher retention of insurance loss due to
catastrophic or concentrated claim experience
policyholder behavior: policyholder act in way has adverse effect to
the company
reserving risk: provision held for policyholder obligation will prove
to be inadequate.

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 In general means the risk of default change in credit quality of issuers of
securities, counterparties, or intermediaries to whom company has an
exposure. Credit risk include:
business credit risk: counterparty fails to meet the obligation,
include reinsurer fails to meet obligation to the company
credit risk invested asset credit risk: risk of non-performance of contractual
payment obligation or adverse change in credit worthiness of
invested asset
political risk: change in government policies that affect
creditworthiness of financial instrument held by insurer
sovereign risk: adverse change in creditworthiness of securities
issued by government or government entities
Market risk arises from level of volatility of market price of assets. Market
risk include:
interest rate risk: losses due to interest rate fluctuation
spread risk: fluctuate of interest rate
equity and property risk: loss resulted from market value fluctuation
of equities and other assets
Currency risk: change in currency decrease in currency value of
foreign asset or increase value of obligation denominated in foreign
currencies.
Basis risk: yield on instruments of varying credit quality, liquidity,
market risk
and maturity do not move together, thus exposing the company to
market value variation that is independent of liability value.
Reinvestment risk: return on fund to be reinvested will fall below
anticipated
Concentration risk: increase to exposure to loss due to concentration
of investment in a geographical area or economic factor
ALM risk: fluctuation of interest and inflation rate have different
effects on the value of asset and liabilities
Off-balance sheet risk: risk of change in value of contingent assets
and liabilities such as swaps that are not otherwise reflected in the
balance sheet
The risk which associated with event such as fraud, system failure, litigation
or regulatory breach within the company. Operational risk include:
human capital risk: not be able to maintain sufficient well-trained
personnel
operational risk management control risk: insurer fail to have appropriate
management discipline or internal control
system risk: computer system failure impair the company ability to
conduct business
strategic risk: company inability to implement appropriate business
plan.
Liquidity risk the exposure to loss in the event that insufficient liquid asset
will be available from amongst asset supporting policy obligation when they
are due. Liquidity risk include:
liquidation value risk: unexpected timing amount of cash needed,
liquidity risk causing liquidation of asset which result in loss of realized value
affiliated company risk: investment in affiliated company may be
difficult to sell. Or affiliated company may drain financial or
operating resource
capital market risk: company could not be able to obtain sufficient
funding from capital market

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 Risk outside control of company which has significant adverse impact. Event
risk include:
legal risk: adverse judgment which affect operation of
company
reputation risk: negative publicity to customer (true or not)
strategic/event causing decline in revenue
risk disaster risk: external major event (missal: earthquake)
that cause system failure which unable company operate in
orderly manner
regulatory risk: negative legislative, court decision, tax
change which alter market or competitive ability
political risk: action by government will impact company to
conduct business
Risk which distribution channel expose the business. Distribution risk
include:
volume of business sold: low sales volume cause high cost per sale.
However if company create strain, high volume also risk.
Distribution risk nature of business sold: distribution is the entry point of this risk,
which will be reduce if the distribution channel likely to reach the
right customer
reputation/compliance: many of compliance issue which company
reputation arise around the point of sale
Expense are too high and has adverse effect to profit. This risk can be
Expense risk managed by combination of: budgeting, expense control, expense analysis
(gain understanding what drivers the expense and specific cost cut project).

It can be challenging to identify the TRUE source of risk. For example, adverse underwriting
experience could be due to a variety source of:

incorrect pricing
risk profile of business assumed varying from that assumed in pricing
underwriting practice actually used varying from those expected in pricing
actual risk experience of the business assumed varying from that assumed in its pricing
faulty claim management

Additional specific risk to each specific insurer:

Specific insurer Additional risk

because product offered often long term in nature, there could
be a risk that:
claimable event will be obsolete. For example due to medical
technology cause lower price of surgery.
Reinvestment risk. Since the contract may have a single or fixed
Life insurance
premium, even though suitable asset with sufficient duration to
match future obligation are not available when the policy sold.
Change in policy holder behavior. For example withdrawal behavior
Longevity risk. Unique to life insurer which sold retirement income
product

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 Health insurance usually sell short-tail insurance product which the claim
settled quickly. In many case there is little scope or no underwriting apply for
each person.
Health insurance
Unique risk: anti-selection risk. Occur when person with better health opt for
cheaper or less coverage, while those poorer health will remain covered and
insensitive to premium change.
General insurance provide wide coverage, usually one year tem, coverage is
high-frequency and low-severity. Important specific risk are:
Volatility risk: total amount of claim is differ from its expected value.
Caused by randomness of frequency, severity, and time to payment of
claim related expense.
Uncertainty risk: divided into
o Parameter distribution used are prone to mis-estimation
o Parameter driving the claim process are not constant over
time
General insurance
o Chooses distribution and other model assumption are not
correct
Extreme event: event occurring with low-frequency and high-severity,
cannot be estimated. Usually insurer relies on reinsurer to manage
this.
Super-imposed inflation: this is specific risk for long-tail business,
long-tail claim which need long time to settle. This kind of claim can
be significantly affected by super-imposed inflation, lead to extra
growth of claim cost.

B. Superannuation risk
Risk can arise from any part of the management of superannuation fund, including

o Plan design
o Investment strategy
o Asset selection and allocation
o Asset liability modelling
o Plan valuation
o Plan administration
o Member education
o Compliance and tax filling
o Financial management
o Performance assessment
o Plan funding
Basic form of
superannuation Risks
fund
Main objective of DB is provide reasonable benefit at reasonable cost
(employers contribution rate). Major risk faced by employee is highly
related with his career with employer. We consider employer risk is that the
cost of fund is excessive and affect viability to sponsor DB. This maybe
Defined benefit happen due to experience in:
(DB) fund Poor investment performance
Salary inflation
Pension inflation
Pensioner longevity: higher than expected rate of mortality
Other significant experience not listed above

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 Defined By fixing the contribution rate, the impact of adverse experience will fall on
contribution (DC) the member of a DC fund. The member should manage this in a similar way
fund with the employer.

C. Fund management risk

Source of income: difference between fee income and expenses. Key driver of fee income is
fund under management (FUM). Growing FUM, drivern by:
Inflow: new fund or existing customer increase fund
Outflow: customer withdraw or transfer fund to another
Investment performance: growth in investment, whether income or capital gain,
increase FUM

Key risk:

Asset offer potential additional return also have downside risk

Pursuit of extra performance demanded by customer may lead investment manager
invest in asset which are not allowed under investment mandate. However, loss of
customer is also significant risk, if the investment is below customer expectation

D. Banking risk
Typical type of business within a global bank include: domestic banking, international
banking, capital market

Bank type Dominant risk

This bank focus on segment retail, small business and commercial.
Dominant risk is credit risk inherent with loans of all type
Domestic banking (mortgage, credit card, commercial loan, etc).
Key challenge: maintain an adequate spread between interest
earned on asset vs that paid out the liability (demand on deposit)
International Risk for domestic bank also apply and additional currency risk
banking from conducting foreign operation.
Focused on corporate loan, derivative, investment banking.
Subject to:
Warehouse risk: risk of loss it has created but cannot be
Capital market sold to investor
Underwriting risk: risk of loss through providing a
guaranteed price when new securities are underwritten
and issued publicly

Risk face generally by banks:

Credit risk
Market risk
Operational risk
Liquidity risk
Strategic/event risk

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2. Risk assessment

objective methodology Deliverable

Assess exposure to loss Qualitative models Understand of gross and
from key risk Quantitative models net risk exposure
Understand risk Develop risk model for
dependencies scenario testing

a) Qualitative vs quantitative
Preferably can quantify frequency and severity of each risk, but sometimes not practical
for some risk. In that case preferably using qualitative method (e.g. risk heat map). Special
for credit risk, usually assessment conducted using sophisticated model using amounts of
experience data.

b) Experienced data
If the business does not have sufficiently credible data of its own, it may be
appropriate to consider relevant industry or market data
Sufficient/credible volume of loss experience can also be gained by using a longer
study period.
c) Risk Model
Used for:
Valuation of insurer liability
Financial condition analysis
Stress and scenario testing
Analysis of asset/liability management
Pricing of insurance product
Evaluation of reinsurance program
Evaluation of various management strategies

In the design of a risk model, it is important to have a framework for risk management
with:
Time horizons: necessary to define the time horizon over which extremely
adverse experience is assumed to be occur
Risk measure: is a numeric evaluator to help determine the financial impact of
the risk. The risk measure that exhibit several desirable properties for various
(but not all) risk is TailVar. In many situations, the risk measure is better suited
to insurance risk than TailVar.
Confidence level: will depend on specific use of the model, time horizon, and
choice of risk measure.
Terminal provision: must be calculated whenever the time horizon is shorter than
the lifetime of the insurers obligation.

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 3. Risk treatment

objective methodology Deliverable

Execute the optimal risk Project implementation bets Action steps for executing
management strategy practice strategy including goals,
responsibilities, resource,
reporting, scope, schedule, etc.

Strategies for managing risk fall into the following major categories:

strategy Description
avoid Eliminate, stop, prohibit or sell risk exposure.
Some reason for seeking to avoid certain risk are:
Reason
Within the risk appetite set by board? No
Within the strategic plan developed by
No
senior management?
Sufficient financial capacity (eg capital
no
and liquidity) to withstand the risk?
Enough internal source to identify,
No
assess, and treat the risk?
Have appropriate process to identify
inappropriate risk management decision no
early
retain Accept and self-insure the risk exposure, eg by integrating it with other
risk or by diversification.
Reason why retain the risk
Reason
Within the risk appetite set by board? Yes
Within the strategic plan developed by
Yes
senior management?
Sufficient financial capacity (eg capital
Yes
and liquidity) to withstand the risk?
Enough internal source to identify,
Yes
assess, and treat the risk?
Have appropriate process to identify
inappropriate risk management decision Yes
early

Benefit of retaining the risk:

Diversification: can be achieved if the risk considered are
uncorrelated
Economic of scale: focus on similar business can be one of
assistance in developing focused business strategy
Reduce Mitigate or cap portions of the risk exposure. Business can reduce their
risk exposure in the event that the inherent risk retained is beyond
their risk tolerances. Risk reduction can be accomplish by:
Disposition/sale: sale part of the business
New business reduction
Transfer Insure, hedge, securitize or outsource the risk exposure. Transfer risk
can be done by:

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 Sharing experience with customers. For example part of
insurance feature depend on the market of investment
performance (in unit link)
Hedging: using derivative to offset market risk
Special purpose entity: a legal entity used for a specific
business purpose while protecting the parent entity from
excessive risk.
exploit Expand and diversify the risk exposure.
reinsurance Reason to buy reinsurance:
Increasing new business capacity
Limiting catastrophic claim
Limiting total claim
Transferring investment risk
Gaining product expertise
Gaining underwriting advice
Diversity a product line
Financial result management

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 Product design
Product design control cycle:

1. Identify the need of new or modified product and develop product strategy
2. Develop the product
3. Manufacture and distribute product
4. Gather and monitor experience

Stage 1 Identify the need of a new (or modified) product

Reason
Innovation
Response to change in
regulation or tax law change
Entry into a new market or
distribution channel
Updating an existing product to
reflect relevant experience
Market research
Explanation
When a product is unique or considerably different from
existing product
May not meet a market need or too expensive compare
to alternative
In insurance industry has been less common
Usually needs existing product to be modified
At least need a different commission scheme
Need market research to determine the appropriate
product for the new market
Copying successful products of competitor is
common upon this reason
This usually result in the need to redesign the product
Market research is one of major tool to identify
market needs
Market research identifies a market need or
confirm a market need exist
Market research confirm that the company has
resource necessary to meet market need
Market research identify competitor and competing
product

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Stage 2 Develop a product strategy

The product strategy will:

1. Discuss how the product fits into companys strategic plan and current product portfolio
2. Discuss specific markets being targeted
3. Discuss distribution method of the product:
since the insurance product are sold, they are not bought, thats why many insurance
product are sold by intermediaries
agent are high cost and only reach a fraction of the population. Usually for selling
complicated feature insurance product
for simpler product and limited underwriting usually sold by direct marketing.
4. Discuss competitive advantages of the company
5. Develop sales and profit expectation for the product
6. Discuss risk associated with the product and ability to mitigate these risk:
Risk can be reduce by the contract design
Risk maybe mitigated through internal or external hedging or reinsurance
7. Discuss the resources necessary for a successful product and evaluate the companys capacity to
meet those needs. Include sufficient capital and access to information
sufficient capital: at least to finance initial expense until they are recouped from premium
access to information: if company has significant experience then it will be more reliable.
If company has limited information the company must use industry data if it is available

Stage 3 Develop a product

1. Project management
Project management principles:

Development of objectives and expectation for the project: especially expectation of stakeholder
should be identified
Ongoing evaluation of the financial implication of the project. To evaluate financial viability
usually using expected cash flow.
Development of a timeline for each step of the project
Assignment of responsibilities for each step. Big task break down into smaller task that more
manageable. Project manager has to make sure it will be completed on time. Frequent
communication between all parties involved is required.
On going monitoring of the progress

2. Design features to control risks

In general insurance usually contain deductible or a coinsurance to share risk with provider
In life insurance, to control the risk usually insurer apply: limited death benefit, non guaranteed
premium, non-guaranteed expense or mortality charges, surrender charged, market-value-
adjusted surrender value, investment linked, participating with profits

3. Competition, marketplace, and pricing process

Pricing the product

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 Competition strongly influenced product design

4. Stakeholder expectation

Provider (stockholders, boards, employees) wants company to be profitable, diversify the risk,
fulfill administrative requirement
Consumer wants the product perform as expected, product design not misinterpreted, provide
benefit promised, give reasonable service and relationship
Retailer want the product compete well, provide benefit promised, support the sale process
Regulator (since insurance are heavily regulated) wants the product: comply with applicable laws,
not misinterpret on sales process, provide benefit promised.

5. Decision to launch the product or not

Must answer:

The product will address a market need?

What will be the cost?
How many will be sold?
How much will be the price?
What is the best for distribution system?
Does it meet profit objectives?

Stage 4 Manufacture and design the product

Distributing the product to the client

Contract and sales material. The language must clear and concise. Must be clear explain about
which benefit are guaranteed and not, avoid misinterpretation
Marketing. Sole agent will often produce a high quality of business. If sold through broker (who
also sell product from another company), the product has to be superior than competitor, higher
compensation for broker, provide superior service to broker, has superior financial strength or
reputation. Quality of the business generated by broker may be inferior quality.

Risk selection
Risk selection is used to control risk including:
Mortality risk on life products
Severity and frequency risk for general insurance
Credit risk on loan

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Administration of the product

Include collection of premium, payment of claim, maintain the current information of policyholder,
reserve calculation. Administration is critical for the long term profit. For example, poor service will
impact product persistency.

ALM

Financial institution will end up with both liability and asset. There must be managed in a coordinated
way. More detail in next chapter.

Stage 5 Gathering and monitoring experience

More detail in next chapter.

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 The Need for Capital

capital is the accumulated wealth of an organization

economic capital: can be viewed as the amount of capital that the firm needs to ensure that it
remains solvent over a certain time period with specified probability
regulatory capital: normally set by the prudential regulator, who is concerned about solvency and
long term sustainability of the entity.

Type of capital

Equity capital: provided by the owners or shareholders of the company, permits the investors to
share in the financial fortunes of the organization. If the company goes bankrupt the shareholder
lose their money because they rank after those who have lent capital to the company through debt
instrument.
Debt capital: normally requires a prescribed payment of the interest and, in due course,
repayment of the loan.
Subordinated debt: refers to unsecured loans whose holders rank behind other debt holders but
ahead of shareholders in the case of liquidation.

Companies with high ratio debt to equity capital are highly geared or highly leveraged. In good time highly
geared company deliver high return but in difficult times they may struggle to cover interest charges..

Financial institution such as banks and insurance companies should particularly aim for a low probability
of failure. Prudential regulator usually require them to hold minimum amount of equity capital. Eligible
capital is type of capital which can be counted in deciding whether the institution meets the minimum
capital requirement, include: tier 1 capital (represent core measure of banks financial strength) and tier 2
capital (include revaluation of reserve)

The reason for capital

1. Providing operational capital, because all organizations need capital to operate

2. Withstanding fluctuation within ongoing operations
3. Consumer confidence, for example: depositors must believe that their money will be available
when required by the customer.
4. Withstanding unexpected shock. To ensure that the companys operations will survive major
financial shock form unexpected event
5. Ability to respond future opportunities or capital needs
6. Credit rating
7. Stability and confidence in the financial system

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The need for capital: perspective of different stakeholder

1. Shareholder/investor. The primary goal of shareholder is to maximize the return on their equity
capital invested, within an acceptable level of risk. However a lower level of equity capital can lead
to a higher return but may also cause a higher probability of failure.
2. Board and senior management. Level of capital is strongly influenced by the boards strategic
decisions in term of the companys product offerings, selection market, as well as its growth and
pricing strategies.

Board strategy decisions

and risk appetite Other sources
of capital

level of capital
required

shareholders risk in business

increasein Market
shareholder pricing
value pressure

performance on
a risk-adjusted
capital basis

3. Regulators. Regulator has a focus on protecting the individual customer and is not primarily
concern with the shareholders return. Often the level of capital required by a regulator is higher
than the level of economic capital determined by a financial institution.
4. Customers. All customer have the expectation that the bank, insurance company or pension fund
will continue to exist and meet its future promises.
5. Rating agencies and market expectations. The goal of the rating agencies is to assess an
organizations financial condition and its possibility of failure. It should be an independent
assessment.

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Financial institution without shareholders

Previous discussion have assumed the existence of shareholders who provided equity capital.
There are 2 important types of financial institutions which do not have shareholders: mutual
organizations and superannuation or pension fund.

Mutual organizations

Some of the issues of capital management which arise for a mutual organizations are:

Permanent capital can only be accumulated from retained earnings. If a mutual funds
need capital unexpectedly, it may be forced to close or merge.
Every organization need capital, it is likely that when their membership eventually
ceases, some members will leave behind part of the earning accrued during their
membership
How to share any operating surplus between some group of members who involve in
various activities such as depositors and borrowers within a credit unions
Since regulator are primarily focused on he customers and not shareholder, when these
individuals are effectively one and the same group. Whether the same regulations and
capital requirement still apply
many mutual have focus on a particular customer or geographical area, which means they
are exposed to additional risk.

Superannuation fund

Employer-sponsored defined benefit superannuation fund

The members are all employees or ex-employees of a single employer, they are promised
retirement benefits based on their service and salary at or near to retirement.
If the fund is relying on future contributions rather than holding assets which are legally
separate form employer, then the members are subject to a double risk a failure of the
employer causes a loss of both their job and their retirement benefit.
From the employers perspective, there would usually be a preference to contribute a rate
does not build up much, if any, buffer in the fund.

Multi-employer (or industry) defined contribution superannuation funds

In these defined contribution (or accumulation) superannuation funds, each members

superannuation account is adjusted to reflect investment returns and cost.

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Risk and capital needs in financial institution

Asset risks event that may cause a reduction in the income generated from, or in the
market value of the assets

Default risk. All asset or investment have a probability of failure such as investor fail to
obtain the expected return form the investment
Market movement. Due to interest rate and the share market move continually, volatility
in the value of certain assets can be significant and hence capital is required.
Concentration, occur when the asset are not diversified. Lack of diversification always
brings additional risk and the need of additional capital.
Liquidity. Not all asset are liquid or marketable. There are some asset that are difficult to
sell especially in difficult economic times.
Other risk. there are several items that are normally recorded as assets in a companys
financial statement which in certain circumstances may be of no or limited value. Hence,
additional capital may be required in respect of these assets, such as:
loans to a related parties (in case of failure of financial group, the value of this
loans is likely to be zero)
future income tax benefits (this asset relies on future profits and in case of a
winding-up, such profit will not occur)
goodwill (this item due to an acquisition of another business or the company
reputation, become worthless in the case of winding-up)

Liability risks events that may cause an increase in the size of liabilities
Pricing. If a portfolio has greater exposure to mis-pricing risk or has a greater level of
guaranteed premiums or fixed repayment, then capital needed to support this risk should
be higher.
Valuation of liabilities. Insurance companies must set aside money to meet liabilities such
as: liability for future benefit, IBNR, OCR, UPR, etc. A lot of factor involve the calculation
of those liability that difficult to predict. Capital is needed in respect of these uncertainty.
Experiences. The actual experience will not exactly the same as the assumption used in
pricing and valuation of liabilities. Again, capital needs to be held by the insurance
company so that it is available to support the financial position of the company should it
suffer adverse experience.
Concentration of liabilities. For example a general insurer expose more risk if most of its
insured located in the same geographical area.
A significant unexpected event. Although insurer have best estimate assumptions, there
are also unexpected event (that beyond control of the company) that may occur from time
to time which can cause significant increase in level of claims or future liability.

Asset/liability risks event that cause movement in the value of both the assets and the
liabilities such as the net outcome is adverse

Liquidity risk.
All organization must be able to meet its obligation as they fall due. But it is unrealistic for
a bank to have all its asset in highly liquid shirt-term as this would limit the banks
lending and investment operations. Hence, in response to this liquidity risk, bank need to
develop a liquidity management that provide sufficient short-term liquid fund to respond
most likely scenario but does not significantly limit banks opportunities.

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 Some incidents that create pressure on liquidity for financial industry: negative media
coverage, collapse of a major employer so that superannuation fund close, major
hailstorm, very poor investment performance
Market risk. Movement in interest rate and market price are likely to affect the value of
both the asset and liability.

Operational risk event that could cause a loss to the company as a result of inadequate or
failed internal processes, people, and systems, from external events. This risk include legal but
exclude systematic risk. for example:

Administrative or transaction errors

Failure of part of the IT system
Mistake in an in-house software program
Fraud
Compliance problems
Poor quality controls or management

An overall company perspective

For the company as a whole, there are a few obvious questions to address:
Given the capital needs of each business unit, what are capital needs of the whole company? This
is question of the diversification benefit
How does economic capital compare to regulatory capital and what are the implications?
What should the company hold in excess of regulatory capital? This is called target surplus
How should the company allocate capital to business units?

Diversification benefits
It is probable that the total capital required within a business unit less than the sum of the
capital required for the individual risk.
Diversification arise if some individual risk move in opposite directions

Economic vs regulatory capital

Economic capital is the amount which the company decides is appropriate
Regulatory capital is the amount calculated by applying the rules set down by the regulator,
reflecting regulators view of certain risk in business in the same sector.
Regulatory capital may be greater than economic capital
When regulatory capital is very far below economic capital, the company may not be well
suited to competing in the market. This is because the company will require a return on
economic capital when its competitors are probably committing less capital.

Target surplus
Target surplus is a capital margin over regulatory requirement. Amount of target surplus that
company decide to hold will depend on its view of its risk, its access to further capital and its
risk appetite.

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Capital allocation
In assessing the performance of its business units, a company will allocate capital (and a cost
of that capital) to each business unit. One of challenge is the allocation of those benefits from
diversification (ie reduction of capital needs) which are achieved through the aggregation of
risk. Allocation will influenced by each business regulatory capital requirement and companys
attitude to target surplus.

Finally, from the companys perspective, the net economic capital represent the capital that it
deems necessary for its activities, given aggregated risk appetite. The importance of this
conclusion is that, in assessing the financial performance of the total company, this generally
represents the appropriate level capital use

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 Modelling and Data
Why model are useful? How model are selected?

Usually involve making simplified assumptions. The simplified assumptions for example:

Quantity is constant over the period

We know the statistical distribution
Aspect influence the model are independent
Some aspect are insignificant
All financial instrument are always priced so as to preclude risk-free arbitrage profit

Case study: actuaries want to make an annuity product. One possible problem is the product might
provide no protection against inflation.

First step in modelling include: define the problem, find the reliable data source, building model and its
alternative.

Using a fitted model

Actuary usually uses the model to advocate the product launch, for example include:

Proposal of a pricing basis for the product, for example providing customer with real
return.
Analysis of products expected profitability
Analysis of products risk
Confirmation that the profit is sufficient given the capital required. Usually achieved by
comparing the return on capital to a hurdle rate.

Throughout the process, actuaries need to deal with:

Marketing team, to gain understanding of competitors price and feature

Operation team, to understand the product cost to be built into expense budget
Sales team, to understand the commission structure and expected target volume
Management team, to gain approval

Challenge the fitted model

Pricing committee wants to ensure the product is profitable (but pursuit of higher margin lead
to lower transaction). Usually the committee will challenge the product developer:

Interest analyzed
Whether the estimated parameter are reliable and how alternative value would affect the
modelling

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 Wider aspect of product design. For example: adverse selection. Super-healthy pensioner are
more concerned about long term inflation, and may find inflation linked annuity particularly
attractive (rather than choose conventional annuity). That means standard assumption are
not valid for this product.

Normative approach to modelling

1. Statistical inference, to test any hypothesis and constructing experiment to validate assumption.
2. Explanatory data analysis. Starting point of model building is collection and analyze the data. The
least formal (but important) stage is explanatory data analysis, means examining data and
looking for pattern.
3. Model calibration, means estimating the uncertain parameters in a model. The most popular
method is maximum likelihood, choosing the most likely set of parameters. Alternative approach
is Bayesian method that treat parameters as being uncertain (prior distribution capturing a
subjective view of where we expect parameter to lie).
4. Fir to evidence. With data, equations, parameters and error term we have a possible model. We
lack of evidence whether the model is correct or useful. The popular tool is stress testing. This test
is simple but will not capture likely behavior outside the data sample to which the model was
calibrated. Alternative approach is to generate several random future projections from the model.
5. Hypothesis testing. We want to see whether the model capture important aspects of historical
data. Usually involve inspection by eye rather than formal statistical test. For example: hypothesis
testing for linear regression problem:
H0 H1
Alternative
Name Null hypothesis
hypothesis
Mathematical
b=0 b<>0
formulation
Estimated b is
Estimated b is
Supportive test not significantly
significantly
result different from
different from zero
zero
Type I and II errors in hypothesis testing
Test result support Test result support H1
H0 (reject H1) (reject H0)
H0 is true Good outcome Type I error
probability 1-alpha Probability alpha
H1 is true Type II error Good outcome
probability beta Probability 1-beta
6. Parsimony. Good data fir becomes easier as more parameters are added, but adding parameters
without limit may violate the principle of parsimony. Parsimony means using only as many
parameters as necessary to fit a model.
7. Fit to theory
8. Computer development. Turning the model formulas into computer code to solve a specific
problem.
9. Using model for projection
10. Bootstrapping, is a powerful but labor-intensive test. The idea is to take a fitted model, taken to be
correct and use this, with a random number generator, to produce data sets according to that
model. This is will test many part of the modelling process.

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Limitation of the normative approach

Practical difficulties
Theoretical ambiguity
Expecting the unexpected

Commercial modelling

1. The role of modelling within the actuarial control cycle. Models are designed to be used over and
over. The shelf life of a model may vary from few a weeks to many years. The model must be
updated, improved, and enhanced.
2. Cost of models and data. Include:
Cost of data collection, cleaning, processing
Cost of estimating model parameters
Cost of model testing and validation
Hardware and software cost of implementation
Cost associated with the use of model output, include communication
3. Robustness, means the model can stand up to challenge, confidence in assumptions,
mathematical formula, and software implementation. Somehow there was some limitation in a
process that make the model not that robust. But management still have to evaluate the risk. The
recipient of a modelling output tries to evaluate several things at once:
The answer to the problem posed
The quality of project management
The quality of the modelling
4. Governance and control, to manage volatility of model output. Governance is the process of
oversight in decision making.
5. Models for advocacy, many modelling project are commissioned for the purpose of advocacy,
especially in long-term actuarial project
6. Models and markets

Data

Quality of actuarial work highly depend on data (factual information used as a basis for reasoning,
discussion, and calculating) and assumptions (a fact or statement taken for granted) used. Some factors
hinder development of the best solutions are:

Lack of time
Lack of resources (computer, assistance, etc)
Lack of data/relevant data
Lack of knowledge about key factors

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Reason why we need data
Present data to give accurate starting point for projecting the future
Past data to use as a guide in constructing model and setting assumption for the future
Knowledge about key factor is essential

Sources of data
1. Internal vs external, internal could be gained from internal company
2. Whole population (census) vs sampling vs survey. Whole population
3. Cross sectional vs longitudinal.
Cross sectional data arise when observation from numerous subject are collected at one
point time. Example: claim payment made in respect of automobile accident during a
fixed time period
Longitudinal data refers to observations collected over time on the same entity. Example:
stock market index
4. Obtaining high quality data. Steps in improving data quality:
Prevention: eliminating errors before they enter the database
Detection: study the collected data in a search for errors
Treatment: repair the data, dealing with errors which have been detected
5. Data checks. Item to consider in data checking:
Know where the data come from
Know why and how the data was originally captured
Understand the incentives inherent in the datas original use
Examine several randomly selected records
Have an expectation of the distribution of the data
Look for blank and duplicate
Ask for the definition of the critical data items
Develop some ways to verify the data
6. Data repair. Common method pf correcting error was return to the source and determine what
went wrong then make the correction. If the correct answer is not obvious and it is not possible to
return to the source, the alternative is imputation, usually by regressing the missing item. If
record cannot be impaired it may have to deleted or at least not used for analyses.
7. Missing or inadequate data.
8. Standard of practice and professional implications. There are few dimension of data quality:
The production of data should be impartial and objective
Relevance: data should be adequate in scope of coverage
Timeliness: delay between the events measured and when the data become available
should be not too great.
Accuracy: sampling error is the most critical components of actuarial studies
Coherence: there should be internal consistency in the data as well as consistency with
regard to previous studies and those by others
Interpretability: data should lead to result which can interpreted by and be meaningful to
users
Accessibly: the data and reports must be available to those who will use them
9. Challenge presented by limited data. For example: liability insurance claim such as medical
malpractice are fairly infrequent. This is particularly problematic when setting assumptions such
as selecting a probability model. Having ten or twenty observation can make this very difficult.

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Assumptions

Control cycle process for setting assumptions:

The assumption- setting control cycle

Steps for assumption setting:
Identify the assumption: list of assumption required
Quantify the assumptions: assigning numerical value
Monitor the assumption: as experience is obtained, it can be used to make appropriate
numerical changes to existing assumptions

Identification of assumptions.
Sometimes it is not so obvious about what assumption should be used. Categorization can help to
identify assumptions. One of the categorization is by source of data used to set the assumption.
Source can include historical experience from:
The same company and product
The same company but different (but similar) product
Similar product sold by other companies
Source unrelated to the company or product

Quantifying assumptions
Actuarial work often uses what is called the best estimate, at least for a starting point. It
usually considered to be the expected value.
Then from that best estimate, prudent estimate can be reached by making explicit
additional margin for uncertainty.
The materiality of an assumption refers to how much impact a change in the
assumption will have on the eventual result. Sensitivity can be used to evaluating
materiality.

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 Pricing
Pricing is determining what a company will charge its customer to provide service.

Pricing process: application of the actuarial control cycle

To develop and implement the product, the following step could be followed:

1. A product, designed in a certain way, is proposed

2. Prices for the product are postulated
3. A model is built
4. Assumptions are set to use in the model
5. Sensitivity and scenario testing is done, to assess vulnerability of the profit to adverse experience
and the scope for additional profit.
6. A report is written summarizing the result of the pricing including an analysis of the risk inherent
to the product
7. Each of these steps is repeated until a decision is made to implement a product

Pricing objective:

Prices is low enough (competitive) so that customer will buy the product and high enough so the
business can meet its profit objective (profitable)

Stakeholders:

1. Owners: provide capital and wants profit

2. Sales intermediaries: wants to earn enough commission
3. Customers: wants to get a good deal
4. Governments and regulators: wants the insurance and financial enterprise to stay in the business
5. Employees: wants to keep their job
6. Reinsurers: they subject to the same risk as insurer

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Description of each pricing process

Pricing Short explanation

process
1 Product Product design can be viewed as: benefit provided by the product and how they pay
design for the product (for customer), include how much the commission pays and how the
commission varies by year (for sales intermediaries)
Interaction between product design and pricing is an iterative process until decision
is made (launch the product or not)
Some reason to change product design: marketing doesnt think that sales goals will
be met, too many competitor sell the same product, price the competitor charge for
the product will not result in an adequate profit
2 Price is The price can be determined by evaluation of all the cost elements (such as expected
postulates claim and expense) plus desired profit
Higher demands is driven by lower price and higher commission (by Chalke)
3 Modelling Model is a representation of reality
Model never precisely correct but useful in managing risk
For example :
Profit (t)=Premium(t)-commission(t)-expense(t)-claims(t)-change in
reserve(t)+interest(t)
Distributable earning(t)=profit(t)-change in target surplus(t)

Target surplus means amount that company wishes to retain in addition to its reserve
to protect against adverse experience.
4 Assumption Process before set assumption:
Understand why the assumption is relevant
Obtain the relevant data. The best data generally comes from a study on a more or
less similar product
Confirm the data is correct
5 Expense Expense is one of most important issue in pricing process
First step is analyzing expense, that is understanding how the different expenses in the
business behave. It need to be analysed into:
fixed, variable, and semi variable
Acquisition and overhead (fixed expense not related to a particular function)
Test expense in pricing. There are 2 approach:
Marginal basis: using variable and the change in semi variable
Fully allocated: including variable and an allocation of fixed and semi variable
6 Profit Profit objective are a measure of how much profit the owners of the business need in order
objective to be willing to finance the company.
Few measure of profitability:
New business strain (difference between income and expense at the time of first
sale)
Profit margin (PV profits divided by PV premium)
Internal rate of return (single interest rate that used to discount all cash flow
resulting present value of zero)
Return on capital (single interest rate that when used to discount all items
projected in the pricing model, excluding reserve and target surplus, result in
present value of initial amount required to establish reserves and target surplus)

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7 Profit Profit testing is using pricing model to measure the expected profit from the product and
testing comparing with profit objective
8 Sensitivity Sensitivity done to determine the specific changes in assumption that cause profit
test objective not to be met.
9 Pricing A well written pricing report (usually in form of product specs) describes the product
report design, recommended prices, the key assumptions and profitability
10 Product Basically this is done by comparing the pricing assumption to what actually happened. The
monitoring product where it was difficult to set the assumption need to monitor more often.

Pricing for long-term commitment

Few common example of long term commitments are: pension plans and funding of retiree
medical cost.
Pricing long term commitments is different from pricing most insurance product that most
financial institution are established for the purposes of making profits.
Objective of pricing long term commitment: is to ensure that expected future income equates to
the benefits and expenses to be provided (not profit). Example: defined benefit superannuation,
the task is to determine the minimum contributions required, together with existing assets, to
ensure that the benefit and expense are paid.
Funding method/actuarial cost method used to determine the expected pattern of contribution.

Method of developing long term commitment solution:

Method Description
1 Funding method in Criteria for this method:
general Member benefits should be fully funded by retirement
The funds asset should equal or exceed the minimum benefit
payable if all member exited
Funding method generally fall into 4 groups:
Pay as you go: do not fund in advance but pay benefits and expenses
as they fall due for payment (doesnt meet criteria but common in
public sector)
Accrued benefit: fund PV of benefit which has accrued during
the time period and pay current expense
Projected benefits: fund PV of all future benefit payment and
expense
Initial funding: fund all benefit and expense at the beginning, which
likely to require a lot of money at that time
The required contribution rate will be recalculated at a regular intervals
PV(contribution)=PV(benefits)+PV(expenses)-assets

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 2 Accrued benefit Major of this category is projected credit unit method (PUCM). Under this
method method, the required contribution rate over next year comprises (express as
percentage of salary):
Value of future benefits payable in respect of service accrued over
next year
One years amortization of the difference between:
Value of future benefits payable in respect of benefits
accrued from service up to valuation date
The assets
3 Projected benefits Most of this category is aggregate method. Required contribution rate is
method calculated as:
The value of all future benefits payable, less the asset held
The value of all future salary payments to existing members

If experience precisely matches assumptions, contribution rate per member under PUCM will
generally commence at a lower rate than aggregate method.

Example PUCM
Annual salary bill= 10 Million
Value of future benefits in respect of service accrued over next year= 1 Million
Accrued benefits= 15 Million
Assets= 13 million

The deficiency is 2 Million. Amortizing over 5 years means that we must contribute 0.4 Million
this year.

Total contribution =
value of benefit accrued over next year in respect of service + deficiency accrued next year
=1 + 0.4 = 1.4 Million

Divide total contribution by annual salary bill gives contribution rate of 14%

Example aggregate method

Value of future benefit for future service of existing staff=22 million
Total value of future benefit for existing staff=37 million
Asset=13 million
Value of future salary of existing staff= 200 million

Thus the deficiency is 24 million (difference between future benefit and asset)
Contribution rate is 12% = 24/200 million

Other application
These concept are applicable to any problem where the cost have to be spread over material time period.
Some other application:
Funding long service leave liabilities
Funding higher education research student
The financial implications of protecting timber plantation from the risk of fire

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 Valuing Liability
Liabilities is basically promise to make a future payment

Liabilities in the account

1. Liability relates to something which has already happened and must represent a current
obligation.
2. The size of equity compared to the liability is often referred to as the strength of the balance sheet
(rough measure of solvency)
3. Liabilities in the income statement can be pictured as:
Profit=income-outgo-increase in liability
( )
Value of liabilities=
(1+)
In reserve valuation usually actuaries will add a prudent margin.
4. A balance sheet prepared to demonstrate solvency to a regulator may involve more conservative
valuation

Typical types of liabilities found in companys balance sheet

1. Short term and long term liabilities

2. Type of liability:
Account payable, for example short term unpaid invoice
Tax liabilities
Debt, can be short term and long term
Provision, are liabilities whose value cannot readily be ascertained as a matter of fact.
Generally their valuation involves the combination of uncertainty of one or all of
occurrence, amount payable and timing

Measuring liabilities

Essential formula:
Liability=PV outgo PV income
1. Best estimate liabilities
Reason for a best estimate valuation:
Measurement of profit
Measurement of capital unemployed, that is difference between a companys asset and
realistic value of liabilities
Allocation of resources
2. Liabilities with margins. Valuation of liabilities is required which incorporates an allowance
for the risk of adverse deviation from the best estimates. This could be a formal step in
demonstrating solvency or a reflection of risk aversion. Risk margins are added to liabilities to
satisfy regulators.
3. Profit margins. Calculation of profit margin using best estimate liability.
4. Market value of liabilities.

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 In many cases there is no obvious market value of liability, in that case, the concept of fair value
may be applied. Definition of fair value of liability is the value at which the liability could be
settled of transferred between willing but not anxious parties.
5. Calculation methodology. Before calculating liability, we must consider whether to use a
formula (with one or more parameter), a deterministic cash flow projection, or a stochastic
projection.
Formula valuation, for example: net premium valuation method
Deterministic cash flow projection, currently most used. It involves constructing a model
of behavior future cash flow and setting assumption for the parameter of the model,
include discount rate.
Stochastics cash flow projection. Deterministic only represent single view of the future.
To incorporate wide range of possibilities actuary will use stochastic model, ie in which
key drivers of cash flow are modeled as random variables and the process of projecting
and discounting the cash flow is repeated many times to obtain a distribution of value.
This method critically dependent on the probability distributions used for the key drivers,
the parameter assumed for these distributions and degree of correlation assumed.
6. Valuing guarantees and options. Most liabilities incorporated some form of guarantees or
option against the company. Guarantee is not only have a value to customer but also have a cost
to the insurer. There are obvious or nor so obvious guarantee, for example:
Point of sale promises: sometimes seller provide some guarantee when selling the
product. This can cause a lot of cost to company if there are some mis-selling.
Consumer protection legislation: in some country there is some regulation that restrict
fee which a product issuer can deduct
Established practice: for example an endowment product that provide non-guaranteed
terminal bonus. If the company not actively adjust the bonuses, in the future a court
would find that its established practice had created some expectation.
Out-of the money-option: usually impact no cost to the company, but in some cases it
has. For example: a saving plan can be converted to a life-time annuity which calculated
with a lot smaller interest rate than market rate when it was priced. But in the future if
the interest rate fall, this would create some cost to the company.
Benefit definition: many life insurance pay benefit where the amount of the payment
depends on the claim satisfying a specific definition. For example; income protection
insurance.

Step in valuing option and guarantee:

Recognize that they are exist

Determine whether they have a material cost or not
Value the option. Can be done by standard formula. However it may be appropriate to
adjust the result to reflect correlation or interaction with other aspects of liability
It could be modelled by allowing simple or complex allowance for future deterioration in
experience
7. Allowing for risk. How to allow risk in a deterministic cash flow projection-and-discount
valuation (in stochastic projection, risk can be allowed directly in the probability distribution
applies in various parameter modeled):
Risk adjusted cash flows: adjust the cash flow assumption e.g. expense and mortality
assumption
Risk-adjusted discount rate: use lower discount rate to become more conservative
8. Other consideration

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 Principle-based vs ruled-based: principle-based concentrate on the purpose of valuation.
Rule-based consider regulation and standard to be followed
Bundle vs unbundle: bundle approach is done by projecting and discounting all cash
flows, implicit or explicitly.
Unbundle approach usually applied for investment linked product. Company profit come
from underwriting profit and administration fee. The company liability may be thought of
as the total account balance less expected value of net future income.
Deriving liabilities by valuing equity: liability derived by deducting equity from total
asset. Calculated value of equity usually called embedded value. If the valuation of
shareholder equity contain risk adjustments (cash flow are discounted at a higher
discount rate) calculated liability will be greater than best estimate.
Deferred acquisition cost. When valuing liability for the purpose of measuring profit, we
generally want to reduce the liability by the amount of unrecovered acquisition cost, so
that profitable new business doesnt appear to make a loss. There are 2 ways of doing this:
Future income considered to be set aside for the recovery of acquisition
cost. Best estimate liability implicitly does this because it allows for all
future income
Establish a DAC asset to offset part of the liability on the balance sheet

Profit and the liability valuation

Valuation of liability is fundamental to the measured profit. Factors that affect the valuation of liability
and hence profit:

1. Valuation objective: may or may not intend to incorporate risk margins

2. Accuracy of the valuation: if the valuation was not accurate and cause high volatility in the future
and so the profit, it might trigger a bad react of shareholder

Practical valuation issues

1. Materiality. If the liability is not material to the account, approximate calculation will suffice
2. Sensitivity. Sensitivity can help actuaries to understand how the choice of bases data and
assumption can affect the calculation.
3. Data. One major challenge facing by most actuaries when valuing liabilities is the availability and
quality of data. The appropriate test to validate data usually:
Ratio and trends
Movement analysis
Comparison with expected
Data integrity, such as Benfords Law to test whether some or all data may be fake.
4. Projection assumption
In setting assumption you need to answer a host of questions, including
What assumption are needed?
How accurate does this assumption need to be?
How realistic or conservative must this assumption be?
How will you derive this assumption?
What constrains apply?
5. Discount rate.

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 Whether the discount rate used are need to allow for risk and tax
Formula for valuation needs to be simple, so it will typically use a single discount rate.
For example: net premium valuation method
Cash flow projection. A more accurate valuation would be achieved by using multiple
discount rate. Other factors also influence choose if multiple or single discount rate:
constrain of the valuation software program,
regulatory requirement (may be an effective requirement to use a single discount
rate)
trade-off between complexity and accuracy
presentation of result, somehow it is easier to explain the use of rates similar to
current market rate for superannuation liability.
Setting discount rate. This include consideration of relationship between interest
rate and discount rate, asset mix, etc

Financial economics and discount rates

Financial economic, including the concept of state price deflator, provides a theoretical framework for
setting discount rate. Two element of financial economic are:

Market price are arbitrage free

Investor require a higher expected return for higher non-diversifiable risk.

1. Arbitrage-free pricing and state price deflator.

An arbitrage opportunity exist in a market when it is possible to make a combination of
transaction that give you something for nothing.
State price = state probability x state price deflator
2. The risk-return trade-off: CAPM
The risk increases so does the expected return required by the investor. this relationship enable us
to construct optimal portfolio of asset which maximize expected return for a given risk. no
additional return can be expected for any risk which is diversifiable. This leads to CAPM equation:
() = + ( )
is the ratio riskiness of the asset to the riskiness of the overall market
3. Actuaries and financial economics. Most actuaries probably derive economic assumption from
CAPM inspires model. This raise some issues, including:
What is the risk-free rate of return?
How much work is justified in deriving the market rate of return, , and the for each
asset class?
How relevant the model for long term?
Most projections require assumptions about returns available of future investments in
various asset classes. Can these be determined using CAPM or state price deflator?

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 Assets

Several different term in asset valuation

Cost price: amount originally paid for the asset

Book value (or carrying value): value at which the asset is held in the company accounts
Amortized cost
Market value: amount that can be realized by selling it at that time on the open market
Fair value: amount that would be paid by a willing buyer to a willing seller. If there is a significant
surplus of buyer, market value is likely exceed fair value.
Useful value (or special value): value of asset according to the user. Some asset may have a
demonstrably greater value to a company than their fair value or market value.
Mark-to-model: when an asset is valued with reference to a pricing model. A valuation at market
value is called mark-to-market. Mark-to-model valuation are used where no obvious market
value exist.

Type of asset

1. Short-term or long term assets

2. Non-investment assets
a) Cash
b) Account receivable
c) Inventory and raw material
d) Capital assets, ranging from computers and other equipment to factory and office
building. This asset depreciate.
e) Intangible assets
f) Tax assets. In Where a company has a net loss, it is generally able to deduct it from future
profits, so it can expect a future income tax benefit, which typically showed in its account
g) Other asset, such as arts, not material
3. Investment assets
1) Physical asset, not liquid, generate income through rent
2) Debt. Generate interest form the money lent to the borrower.
Debt instrument are distinguish by:
Issuer. For example, government is generally seen as risk-free borrower
The way interest paid. Generally interest paid are fixed (same coupon is paid each
period)
Whether the borrower provide collateral
3) Equity, share the ownership. The risk is higher since the creditor must paid first before
the owner. Company which has ownership share: limited company (liability of the owners
for the companys debt is limited to the unpaid portion of their shares), public company
(share are offered to anyone, traded in the stock market), private company (share holder
right to sell their shareholding is limited)
4) Hybrid asset. Typically a combination of debt and equity. For example:
Convertible bonds: pay interest and can be converted to equity

Page | 39
 Preference share (or preferred stock): which are a form of equity but which rank
ahead of ordinary shares
Stapled security: separate equity and debt instrument are issued together and
cannot be unstapled.
5) Derivative. Derivative asset will protect (hedge) the profit of investment portfolio. Three
kind standard of derivative:
Forward contract. Contract to supply certain amount of something at certain
price and certain date (called future contract when issued in a standardized form
by operator of an exchange)
Option, contract giving one party the right to buy (call) or sell (put) an asset at a
specified price (strike price) within or at the end of certain period.
Swaps. Contract to exchange a cash flows.
6) Securitized asset. The asset which are not readily marketable can however be made
marketable by turning them into securities, the process called securitization.

Valuing Asset

Principle of valuing asset: value economic contribution that can be obtained from it, discounted
cash flow (DCF)
If DCF asset give lower value than todays market value, better to sell it in the market.

No Asset Valuation
1 Expected future interest payment and return of the principal at the end
of the term.
Bonds
Market value of government bond with different maturities imply a
yield curve. Form this, a risk-free yield can be deducted for a
particular term.
2 Expected future dividend, usually form a perpetuity.

=
( )

=
( )

Shares =
( )

Dividend (D) grow at rate g, and its discounted at rate d.

P/E is known as the price-earning ratio and publicly quoted for all
listed share.
Assume ratio between dividend and earning is D=rE
3 Expected cash flow comprises the rent to be paid by tenant less the cost
Property
of ownership.

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 4 Future and forwards contract is imply agreement to deliver, present
value of deliverable is always the settlement price, discounted at
risk free rate
Derivative
Options. Valuation approach by using Black-Scholes option pricing
model, or by replicating portfolio of asset which generates the same
cash flows as the derivatives in all circumstances.

Asset risk

Valuation of asset can change for two reason: expected cash flows or discount rate change.

No Assets Key risks

1 Credit risk.
Bond and
Debt with a lower credit rating from recognized rating agency will tend to be
other debt
priced at higher discount rate than otherwise identical debt with a higher rating
2 Any event that affect the companys earning will affect its share value. Such as:
Share
insolvency, market sentiment.
3 Loss of prospective rental income, such as loss of key tenant
Property
Area surrounded the property become less attractive
4 Return is considerably less than anticipated
Counterparty doesnt payout settlement, either because it claims that is
derivative not required to (legal risk) or because it cannot pay (credit risk)
Margin call (there is a liquidity risk associated with temporary adverse
movement)

Asset-liability management

Sometimes, asset exist because of the activities that gave rise to the liabilities.

Four basic risks associated with the relationship between asset and liabilities:

1) Return on asset is insufficient to enable the obligations to be met as they fall due
2) Illiquid assets have to be sold cheaply to meet cash flow needed (liquidity risk)
3) It is not possible to reinvest surplus asset cash flow (interest, dividends, and the proceeds
of sale or maturity) or, in reverse, to obtain refinancing in manner that avoids both
(1) and (2)
4) The valuations of assets and liabilities will give rise to deficiency, even where the assets
may otherwise be thought to be sufficient.

Cash flow matching. To reduce or eliminate asset/liability risk is to match cash flows. If the assets cash
flow will be the same as the liabilities in all circumstances, there will be no asset/liability risk at all.
Another cash flow matching technique is reinsurance.

Page | 41
Immunization. Portfolio of business can be immunized against changes in interest rates by ensuring
that assets satisfied the following condition:

PV assets=PV liabilities at the market interest rate

Duration of assets=duration of liabilities
Spread of the cash flow about the duration is less for liabilities than for the assets.

Asset-liability management constraints

1. Investment mandates. Investment manager have to make sure that the mandates is not
too constraining
2. Investment product offerings. Sometimes unit-linked buyer given the choice of fund
options.
3. Legislative constraints. For example in order to access certain significant tax concessions,
life insurer were one required to hold 30% of their asset in public securities.
4. Capital requirements. Regulators require companies to hold capital to reduce the risk of
the liabilities exceeding the assets (insolvency). The regulators point of view of capital
requirement may be quite different from the companys own view and can result in
change to the companys preferred investment strategy.
5. Access to capital. If there is an adverse asset outcome relative to liabilities the more
capital required to restore the position. When the capital is not readily available, it can be
very serious. Therefore the company have to manage it.
6. The impact of tax and fees.
7. Impact of negative return.

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 Solvency
At the very last, a company must meet the legal minimum standards for solvency
The regulator must find a balance: aiming to protect the security of consumers without impeding
the efficiency of financial markets.

An insurance company is solvent if it is able to fulfill its obligation under all contract under all reasonably
foreseeable circumstances:

Cash flow solvency (or liquidity): will the company be able pay its debts as and when they fall
due?
Discontinuance solvency: if the company ceased doing business today, would the company be able
to cover its obligations?
Going-concern solvency: If the company remains in business, following a specified business plan,
will it continue to be able to meet its liabilities in the future?

Cash flow solvency

1) Liquidity risk in normal conditions

Liquidity ratio can be used to monitor a financial institutions liquidity.

=

2) Liquidity risk in a crisis
Liquidity risk is more likely to be a problem for a company that is already in a weakened financial
state. Liquidity problem can also create solvency problem:
Financial institution that needs to borrow money quickly may incur high interest cost
Money might be raised by selling asset but a forced seller of illiquid assets may receive a
price that is well below the normal market value.
3) Managing liquidity risks
a) Product design: by including penalties for early withdrawal, and/or by giving the financial
institution the option to defer payment
b) Marketing: do not emphasize the feature of liquidity option (i.e. guaranteed surrender
value) a desirable feature of the product during the sales process
c) Pricing: the price of the product should reflect the cost of providing any liquidity option.
d) Risk management: understand the nature of the risk and to be well diversified. The more
diversified the customer base, the lower risk.
e) Investment: maintains an appropriate level of liquid assets, sufficient to cover cash
outflows in the ordinary course of business, with a margin of safety.
f) Asset-liability mismatch: borrowing short-term and lending long-term creates liquidity
risk. both assets and liability should be laddered, i.e. it is better to have a series of
regular, small cash flow instead of infrequent large cash flow.
g) Contingency plans: each financial institution should have plans for accessing additional
liquidity in an emergency.
h) Solvency: as confidence may trigger a liquidity crisis (so any company that has solvency
problems has a higher liquidity risk), it is important to maintain a close relationship with
the major rating agencies and to heed their concerns.

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Discontinuance solvency and going-concern solvency: general approach

Company that is currently solvent in the short term, ie on a cash flow basis, may not be able to
meet its obligations in the long term. The cash flow may be fine for many years as long as the
company keeps growing, but as soon as growth stops, the company collapses.
What regulators wanted to know was: if the institution ceased operations today, would the assets
be sufficient to cover the liabilities? If the company remained in the business, following a
specified business plan, would it continue to be able to meet its liabilities in the future?
Regulators were interested in discontinuance solvency and going-concern solvency

Alternative form of discontinuance

There are three possible courses of action when an entity ceases operation:

1) Winding up: the assets are sold and the proceeds are distributed among creditors.
2) The institution stops writing new business or renewing existing contract, but continues to
run off its existing liabilities in an orderly manner.
3) Transfer of business: another stronger institution takes over the liabilities, along with
sufficient assets to cover them. From customer perspective this is the best option.

Measuring discontinuance solvency

To assess discontinuance, one would:

a) Determine the value of assets likely to be available to pay off the liabilities in a
discontinuance situation
b) Determine the value of liabilities in a discontinuance situation
c) Determine the minimum amount of additional capital that should be set to absorb losses
d) Assess the amount and quality of capital that would be available to meet obligation

Solvency ratio is (d)/(c)

Valuation of assets for solvency purposes

For solvency purposes, the value of assets that appears in the companys account for general
reporting need to be adjusted, because:

In some cases the value of asset may be reported based on cost or using a discounted cash
flow, rather than market value.
Market value of discontinuance situation may well be less than the market value of assets
under normal circumstances. The following assets may be of little or no value in the event of
winding up: intangibles such as good will, assets whose value depends on the continued
existence of company such as future income tax benefit, asset that may be difficult to collect
if the company become insolvent, such as unsecured loan.

Asset value should be verified by external auditor.

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 Valuation of liabilities for solvency purposes
For solvency purposes, insurance and pension fund liabilities are often valued using one or a
combination of the following methods:

a) The statutory valuation basis.

Require liabilities to be valued as the PV of expected future cash flows, calculated using
methods and assumptions that specified by regulatory authorities. The assumptions are
deliberately choses to be conservative, so that the value of liabilities includes an implicit risk
margins.

b) The margin for adverse deviation method.

This method allows for differences in the risks underlying each companys liabilities.

c) The probability of sufficiency approach (quantile method).

This methods approach is based on modelling the distribution of all possible outcomes for
claim costs. The actuary aims to determine the amount of reserves that will provide an x
percent probability of covering the claims. Target value of x is determined by the regulator or
insurers BoD.

The value of the liabilities shown in the accounts is generally based on the assumption that the business
will be ongoing. In the event of discontinuance, adjustment needed.

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 Profit
Overview of Profit
Profit is the measure of economic gain over a period. In general accounting terms, profit is determined as
the difference between income and expenditures for a specific time period.

Profit in respect of the insurance operation of an Insurer can be expressed as:

Profit = Income Expenditure

= (Premiums + Investment Incomes) (Claims + Expenses + Tax + Policy liabilities)

Reported versus distributable profit

The traditional view of profit

The traditional view was that profit really had no meaning until the last of the business had gone off
the books and all outstanding claims had been finalised. The reason of this approach was the
uncertainty of the estimates of future experience and the resulting impact on the value of policy
liabilities which, of course was a key determinant of the amount of either profit or surplus.

The modern view of profit

The modern view is that while the estimation of policy liabilities (and also profit) is uncertain, a
current measure of profit is nonetheless essential for shareholders, regulators, policyholders, and
other users of financial statements to measure of realistic progress of the business.

The modern view recognises that uncertainty in estimation future experience for insurers is
conceptually, no different from the uncertainty inherent in profit measurement for many other
industries. The calculation of profit for an insurer may now be considered to be accepted practices.

Profit measurement versus solvency

It is important to understand the critical tension between realistic profit measurement and questions
of solvency or financial stability between traditional and modern view of profit.

The traditional view reflects an environment in which the actuary determined the distributable
profit, ie the amount that could be produntly distributed to policyholders (as bonuses) or to
shareholders (as dividens). The priority was to ensure that there was sufficient surplus to maintain
the solvency of the company into the future. The modern view recognises a clear distinction between
reported profit and distributable profit. As the measurement becomes increasingly comprehensive
and independent of the profit reporting basis, so the profict reporting basis can be freed to focus on
determining a best estimate profit measure. Financial reporting of many industries and some
financial institutions do not clearly distinguish between reported and distributable profit.

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The emergence of profit
Sources of profit
Profit could be thought of as having been generated from three sources:

- Investment earnings on the net shareholders funds of the busines held in cash deposits or
other financial instruments (eg bonds, shares or property)
- The profit margin explicitly or implicitly built into the pricing of products
- Deviations of actual experience from that which was expected in the product pricing

In insurance context, the measurement of profit depends on the calculation of policy liabilities
(reserves). The precise definition of that calculation is clearly central to the outcome. Change
in policy liabilities is one of the most important inputs into calculation of profit.

Assumptions made for three sources of profit mentioned above could be different with
assumptions used in the calculation of the liabilities. Differences will affect the reported profit.
This is a fourth source of profit.

Real profit is represented by the three sources listed above. Measured profit is the real profit
adjusted by the effect of the differences of pricing and liabilitiy assumptions. The emergence of
profit is a description of the way in which the measurement approach allows the real profit to
emerge.

When the policies have terminated, the total measured profit since the first policies were
issued will be equal to the total of real profit over the same period but its emergence will have
had a different pattern.

Timing of profit recognition

Margin of Services (MoS) for Australian life insurers is a profit reporting mechanism whose
foundation is a specific approach to the timing of the recognition of profit. It prohibits
recognising future profit at commencement and requires that profit be recognised as the
services provided to the customer during the period of the contract actualy delivered.

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Emerging costs

On defined benefit superannuation, the financial institutions have commitments for long-term nature
instead of profit making. They are ensuring that the expected future income equates to the the benefit and
expenses. The task is to determine the minimum contributions required together with the existing assets
to ensure that the benefits and expenses are paid.

Funding methods
Criteria that should be satisfied for an appropriate funding method:

- Member benefits should be fully funded by retirement

- The funds assets should exceed the minimum benefit payable if all members exited

Four groups of funding method

- Pay as you go (PAYG) do not fund in advance but pay benefits and expenses as the y fall
due for payment
- Accrued benefit fund the present value of benefits which have accrued during the time
period and pay current expenses
- Projected benefit fund the present value of all future benefit payments and expenses
- Initial funding fund all benefit and expenses at the beginning

The required contribution rate is the solution of the equation:

PV Contributions = PV Benefits + PV Expenses Assets

Accrued benefits: The major funding method in the accrued benefits category is the projected
unit credit method. Under this method, contribution rate over the next year comprises two parts
(1) value of future benefit payable and (2) one years amortisation of the difference between the
value of future benefits payable and the assets), and both are expressed as a percentage of one
years salary

Projected benefits: The major funding method in the projected benefits category is the aggregate
method. Under this method, contribution rate is calculated as the value of all future benefits
payable less theh assets held divided by the value of all future salary payments.

If actual experience matches with the assumptions, the contribution rate using projected unit
credit method will generally commence at a lower rate than under aggregate method. But it will
increase as a members age increases until it exceeds aggregate method which will remain a
fixed percentage of salary for the term of the members membership.

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Appraisal values
Actuarial appraisal value is a discounted cash flow valuation technique representing the present
value of all future distributable cash flows from one or more blacks of business. The appraisal value
includes the future cash flows from existing block business and from future new business.

Appraisal value purposes is valuing the company from the perspective of shareholders. The focus will
be on distributable cash flows rather than just profit. The relationship is captured in formula below:

Cash Flow = Profit capital

For expanding business, the capital requirement is usually increasing, meaning that cash flows are
less that profit. If we are not allowing for new business additions, then the cash flows will be larger
than profit because capital is released as the business which it supported exits.

Price/Earnings multiple is used to valuing equities. If the price (ie the value) is some multiple of
earnings, the multiple can be decomposed into the following

Multiple = (1+g)/(r-g)

g: expected growth rate of future earnings

r : discount rate for future earnings

Components of an appraisal value

AV is calculated via three components below :

1. Net worth (assets)

All financial institutions will have material amounts of net assets to provide the necessary
capital adequacy required by the regulators. The market value will be used for valuing the
net assets.
2. Value of in-force (VIF) the value of future cash flows from existing business
VIF is calculated simply by projecting the business until its expiry. The cash flow
distributable to sharholders is :
Cash Flows = (Premium Claims Liabilities) Expenses Capital + Investment
Income

If capital is deducted from the value of the in-force business, this gives:
VIF = PV Inforce Cash Flows Capital(0)

The sum of net worth and VIF is called embedded value (EV):
EV = Total Assets Liabilities Capital + PV Inforce Cash Flows

Target surplus is the excess of capital from minimum regulatory requirement.

3. Value of new business (VNB) the value of future cash flows from future new business
Two interpretation of VNB :
a. It is the value of the infrastructure (product range, distribution channels, brand,
competencies, technology platforms and physical infrastructer) which allows the
company to be able to write profitable business in the future, or
b. It is the value of the best estimate of the profit to be achieved from writing future new
business

Page | 49
AV as a profit measure
An alternative view of profit is to view it as the value addaed by the particular time period. The
value added is the difference between the present value of future profits, with allowance of any
capital requirements, at the end and the beginning of time period. This present value is the
appraisal value.

Many institutions use the change in AV as an important internal measure of performance. As a

results, the AV has become an essential measurement tool.

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 Monitoring Experience
Why do we analyse experience?
Below are the reasons of why the actuaries analyses the experience:

Reviewing our previous assumptions there are informations once when we compare the actual
outcomes with the expected outcomes based on our previous assumptions. These informations
are important piece of input into the review of previous assumptions.
Providing understanding of the drivers of the emerging experience understanding the reasons
for the experience that has occured was adverse or advantageous. Some cases that the
deteriorating experience is due to the results of a particular subgroup in the business.
Developing a history of experience over time If data available for only a single time period of
experience, it would be necessary to give credibility to the conclusions drawn. The accumulation
of experience over several time periods will provide greater volume of data and hence greater
credibility. Accumulating data also can help us to picture of the changes of the experience over
time.
Aiding in an analysis of profit and its sources validate the profit by analysing the profit into its
various sources like the difference between actual and expected experience.
Providing information to management the observed experience is an important piece of input
for management decision making process. Without it, management is severely constrained in its
ability to respond appropriately.
Providing information to shareholders adequate information for disclosure from analysing the
experience is a requirement of good corporate governance for shareholders. Information for
shareholders is highly aggregated so that they only receive high level analyses.
Satisfying regulatory requirements actuaries needs to submit their analysis of experience to
regulators.
For public relations purposes analyses of experience is a part of disculosure to stockmarket
analyst, the media, market researchers etc for the purposes of improving image of the company to
the customers, potential customers, politicians, etc.
Satisfying disclosure requirements in a listing or acquisition situation information must be
disclosed when companies is listed on the stock exchange or involved in acquisitions either as a
buyer or seller.

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What do we analyse?
In general, we only will analyse the important experience items which determined by the financial impact.
In deciding which experience items are important, initial review or sensitivity testing are needed to
determine which ones leads to material financial impacts. It is important to not lose sight on an item that
which initially not showing material impact because an accumulation of small changes could become
material. It sound actuarial practice to periodically review all those minor experience items to confirm
their continued minor status.

The experience items for analysis fall into five main groups:

1. Demographic
a. Claims
b. Persistency
2. Economic
a. Investment performance
b. Inflation
3. Expenses
4. Business volumes
5. Profit and return on capital

Variatons in any experience item will impact on the profitability and some impacts from one experience
item will link to another (e.g lower volumes of new business can lead to excessive expense per unit).
Across different types of institutions, the importance of the same item can vary markedly (e.g
deteriorating investment performance has more impact in superannuation but it is a minor issue for
term-life insurance).

General Insurance
Experience items which usually need to be analysed in general insurance: persistency (rate at which
policies renew), claims experience (include the rate at which new claims arise, the rate and amount
at which claims ultimaltely settle, and rate of inflation)

Life Insurance
Experience items which usually need te analysed in life insurance: persistency (the inverse of the
rate ath which policies lapse or surrender), partial withdrawals (especially for investment
products), experience related to risk business (claims mortality and morbidity), and experience
related to investment business (investment performance, persistency, expense rates).

Funds Management
Investment performance is material for wholesale business but much less so for retail business. The
major driver for profitability will be the expenses and in the case of retail business is persistency.

Superannuation
For defined benefit superannuation, the main issues are investment performance and salary
inflation. This relationship ofter referred as the gap. If the gap is greater than that assumed when
calculating contribution rates, they will be more than adequate and vice versa. Contribution rates
are highly sensitive to this item. For accumulation superannuation, all the investment and salary
inflation risks are borne by the member unless there is any element of capital-guarantee. The major
risk for the fund is that of expense is being greater than charged to members.

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Banking
In banking context, claims experience is a rates of default on various loans which affects assets
rather than liabilities. It is strongly correlated to economic conditions, not only to how bank
evaluating the prospective customers. Other crucial experience item is the interest margin (the
difference between interest rate a bank has to offer to obtain deposits and the rate it is able to
charge on its loan book). Expenses also have a major impact on profitability hence the most
published measure of bank performance is the cost to income ratio.

Health Insurance
The key issues are persistency and claim rates since conceptually, health insurance is another form
of risk insurance. A major driver of claim cost is inflation of medical expenses. Premium for health
insurance are almost always a matter of political importance. Hence the credibility of experience
analyses which are relied on to justfy rate increases is of more importance than in some other line
of business.

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How do we analyse experience?
Below are overall approach to analysing experience:

- Establish the objectives

- Collect the data
- Assess data quality
- Validate the data
- Perform the analysis
- Validate the results
- Report the results

Demographic
The analysis of demographic items generally follows one of two methods below:

- Actual versus expected calculate the expected outcome using a specified set of assumptions
then compared with the actual outcome for the same quantity over the same time period.
- Calculate the actual rates this method is rare since we generally do not have sufficient data
to allow us to reliably derive a set of smooth rates for demographic items. Even with
sufficient data, the purpose of experience analyses is to compare our original models and
assumptions with the actual experience.

Economic
The three key economic items which reflect our individual experience are investment
performance, the rate of inflation experienced by our own expenses inputs and the rate of
superimposed inflation shown in our long-tail general insurance claims.

Expenses
The actuarial analysis of expenses is directed at understanding the drivers of those expenses and
hence the way in which future expense cash flows can be projected in such a way as to closely
approximate the expenses which will arise from a given pattern of business. Expense data comes
in a two dimensional form. One dimension is the type of expense (salaries, premises, advertising,
etc) and the other will be the organisational unit.

- Step 1: division of expenses by function and product

Divide the expenses according to function and product group. The functions are sales,
marketing, investment management, claims administration, underwriting, etc and those
relating to overhead (not directly to product). Internal allocation could be organised by staff
surveys to indentify the proportion of time that is spent on each product or function.
Overhead is designated for any organisational units which provide service not directly to
product related function.
There are two categories of expenses: fixed and variable. Variable expenses will vary directly
with business volumes while fixed expenses are largely indpendent of business volumes.
- Step 2: allocation of items
In this steps, we are attempting to identify business statistics which will appropriately
represent the key drivers of expense when related to business volumes.
Commission normally the easiest item because the rules for commission are known.
The drivers are basic initial commission and renewal commission. Other items of
commission (overrides, volume bonus, and persistency bonus) are modelled as they
relate to the characteristics of the whole business introduced by a particular distributor.

Page | 54
 Policy administration expenses fundamentally driven by the number of policies
because the costs of processing renewals are asserted to be independent of the policy
size.
Underwriting expenses normally driven by sum assured and depend on underwriting
requirement on the particular products. The reasonable assumption is underwriting
expenses increases as the sum insured increases.
Claim management expenses will driven by claims which require most investigation.
The reasonable assumption is the major driver of claims management expenses is the
actual claim expenses.
Investment expenses driven by the volume of funds under management by asset class.
If there is no information about assets class, we can assume that investment expenses
will still be driven by funds under management.
Sales management expenses it is likely that the drivers of sales management expenses
could be represented by commission by distribution channel.
Marketing expenses some marketing expenses can be described directly to a particular
products (brochures, product development) while others are applicable to the whole
marketing effort. New business volumes are often used as the drivers of product specific
marketing expenses.
Finance and general management expenses material component which is best
described as related to the business as a whole (eg preparation of published accounts
and other shareholder information, capital management, and contribution to overall
strategy) component is in the same category with general management expenses. The
potential drivers are profit, premium volumes, funds under management. One approach
is to assert that the time of general management will be usually divided according to the
importance and size of the various organisational units. A measure of size could be
taken as the expenses of that organisational unit. This measure of size will be closely
related to staff numbers (headcounts).
- Step 3: comparisons and conclusions
After first two steps are completed we will have a set of expense drivers and the actual
expense rates for each of those drivers. We can compare the latest period with prior periods
and draw reasonable conclusions.

Business volumes
Analysis of business volumes should cover new business and in-force separately. The analysis of
in-force volumes is primarly an outworking of a proper analysis of the demographic factors.

The models should have an expected take-up rate of the increases of consumers level of covers
(which in real terms are constant) and an analysis of actual versus expected appropriately
segmented will provide information for updating models.

For investment contracts, the models should have allowed for an expected rate of change in
annual deposits (or premium) independent of rates of persistency. In context of retirmement
savings products, we will expect an increase in contributions consistent with the rates in
remuneration. For self-employed, the rates of contributions is likely to have some relationship to
the customers businesss profitability.

A typical analysis of new business compares current period with the previous period and
highlighting the reasons of difference.

Page | 55
Data issues
All analyses of experience are dependent on quality of the data used as the foundations. Since the most
data used the experience analysis will be secondary use of the data, the expected quality will vary
depending of the primary use of the data. Data used in producing audited accounts (eg expenses) can
reasonably be regarded as of high quality. This is also the same with business statistics as they are the
basis for regulatory reporting.

Data validation is an important part of any experience analysis. At a simple level the comparison of in-
force regular premium against the regular premium income in the accounts for the same period can easily
provide an alert for a potential probelms with the premium data. Often an exact data required is not
available and approximation must be accepted.

Page | 56
Responding to Experience

Role of the actuary

The actuary makes recommendations to the governing body of the employer of client, but the
decisions on and implementation of the recommendations are the responsibility of that body. In
formulating actuarial advice it is important to identify who is the client and what is the exact scope
of the work. Clarifiying this as early as possible can save time later in the process. Often the actuary
may identify improvements that can be made to the clients business or operation but which are not
strictly included in the scope of the assigment.

General considerations
When responding to the experience of a financial entity, various general considerations apply
across a range of assignments:

- Legal constraints encompasses specific legislation and regulations relating to the client
entity, other legislation and regulations covering business behaviour (non-discrimination,
competition, and selling methods)
- Professional standards and guidance notes this includes non-actuarial standards (eg.
accounting standards)
- Equity and fairness require actuary to seek outcomes which are fair and equitable between
different groups involved in enterprise
- Business plans and objectives the actuary should have regard to the business plans of the
client or employer and develop recommendation which are consistent with those plans
- Competition seeking the best outcome for the entity and the need for the entity to remain
competitive
- Capital requirements
- Profit recognition

Managing the business

Business plans
Business are managed in accordance with a business plan which is usually developed by
management and approved by board of directors or other governing body. It begins with vision
(why a company is in business) and mission (how the company achives its vision) followed by more
detailed goals and objectives to achieve the vision and mission.

It is important for the actuary to be aware of the business plan and objectives of the business. The
actuarys recommendations should be framed in a way which supports and is consistent with those
plans.

Financial control systems

Financial control systems allow management and the Board to track performance against the
business plan and to make changes as needed to keep the business on course. Reports are often
produced monthly and approximation may be used where year-end process are complex or
expensive. Control systems include comparisons of the following items

- Sales volumes by product

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 - Profit by product and an analysis of sources of profit
- Credit control and liquidity position
- Management expenses
- Investment returns, claims, and lapse results
- Other key performance indicators agreed for the business (eg staff turnover or customer
satisfaction)

Audit systems
The financial reports of most companies are audited annualy and these reports often form an
important input for the actuarial assingment. The actuary should understand the nature of the
audit process, the scope of the audit, the level of materiality adopted by the auditor and any
recommendations made by the auditor to management.

Expense management
- Measuring expense performance actuarial control usually involves a measure of actual
versus assumed expenses by categories of expense. One common actuarial approach to
expense analysis is to calculate an expense ratio which is the ratio of actual expense to those
would have been expecteed based on assumed expense rates and actual volumes. The
denominator of this ratio is called the expense allowance. Expense overrun is a condition when
these ratio is greater than one.
- Improving expense performance the important objective is to reduce expense ratio
progressively over time in order to be competitive thereby improving profits or customer
benefits or both. This can be achieved in a number of ways below:
o Increasing volumes of new business to achieve economies of scale
o Retaining more business, on the basis that renewing business is usually more cost-
offective than obtaining new business
o Increasing assumed expense rates and either increasing product prices or accepting lower
expected profitability
o Business review process which result in lower costs
o A combination of all or several of the above.
- Outsourcing
Management expenses can be reduced by outsourcing administrative functions to a specialist
manager

Capital management
- Capital requirement
Most businesses require capital to fund fixed assets, stock, and debtors. Capital requirement
generally increas when a business is growing rapidly. A financial services entity often has
additional requirements for capital in order to demonstrate financial strength. Capital
requirements are a function of the business risk accepted by each business.
- Charging for capital it is usually possible to raise more capital so long as there is an adequate
return to the provider of the capital. When financial products are designed and priced, the
level of inherent risk in the product is assessed and the cost of the required capital support
should be included in the pricing. Actuaries must allow for capital requirements when
allocating and distributing profits to the various stakeholders in a business. The key aspect
here are :
o Meeting capital requirements is a first priority when considering the distrubtion of profits
from a business

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 o In allocating profits between groups of customers with different levels of investment
guarantees, it is important to consider the cost of capital required to support these
guarantees
- Optimising capital requirements business risks and resulting capital requirements are not
static but change over time as a result of changes to product terms and conditions, product
mix, underlying profitability and changes in economic conditions. Some example of ways to
improve capital usage:
o Reduce business risks
o Reprice products with declining profitability to ensure that safety margins are maintained
o Review product terms and conditions and develop new less capital-intensive products
o Increas the diversity of the business through higher volumes, wider product range,
different distrubition systems, etc

Allocating interest to accounts

Some basics process of the distribution of investment income

- Determine the amount of investment income this is include realised and unrealised capital
gains and losses.
- Allocate this between customers or members and any shareholders and between different groups
of customers a common method of allocation and distribution is by using an interest rate
declared on an account balance.
- Distribute the income consistently with the allocation using average of actual return to
smoothen the investment return over time. Smoothing is usually managed by holding back part of
the return during good years and using this to subsidise rates during periods of poor returns.

Unit pricing
An alternative to distributing the returns is using a unitised method. Customers or members are allocated
units in a pool of investments and the unit price reflects subsequent investment earnings including capital
gains and losses. At any point in time, the unit price is calculated as the value of the investments in the
pool divided by the number of units. New investments or withdrawals require the purchase or sale of an
appropriate number of units at the unit price on the day of the transactions.

There is no need for a response to the experience if the unit pricing using daily pricing. Some intervention
will be required to handle sudden and severe volatility in markets.

Key design and management issues in unit pricing are:

- Transaction can be made at unit price determined in advance or in arrears

- Transaction costs, such as brokerage and stamp duty may be charged to unitholders who are
buying or selling through differential buying and selling unit prices
- Transaction may be backdated where promises are made to intending customers but there is
some daly in processing the transaction
- Current market prices for some assets are not available at the time that unit pricing is done
- Unit pricing includes an allowance for income tax payable on investment income and net realised
gains
- Unit pricing also includes an allowance for deferred tax because unrealised gains and losses will
give rise to tax liabilities of benefits when ultimately realised
- Sophisticated systems are needed to enable accurate unit pricing on a daily basis

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Review of insurance pricing
Review of experience
The starting point is a detailed review of past experience including:

- The experience of the client if it is large enough to be statistically significant

- The experience of the industry if it is relevant to the business of the client
- The experience of competitors as evidenced by their pricing but note that some caution is
required in interpreting this

Pricing changes
Actuaries should be able to develop test pricing which covers expected claims and includes appropriate
margins for managament expenses, cost of capital and profit, in line with the business plan.

If the test pricing is lower than the existing pricing, actuaries should consider to using some of the
margins to improve policy benefits or increase commissions or profits rather than reducing prices
(reducing prices may be quickly copied by competitors and may start a pricing war in the industry). If
the test pricing is higher than the existing pricing, considerations needs to be given to the attitude of
existing customers and potential new customers. For life insurance, companies need to consider
whether to apply the new pricing to existing customers or just to new customers.

Competition
Competition is a critical factor in repricing. The pricing policy of the client or employer needs to be
taken into account including aspects such as :

- New business volumes required by the business plan

- Product terms and conditions compared with competitors
- The competitive advantages of the business (quality of service, financial strength, control over
distribution)
- Whether the product is a core product or an accommodation line, where pricing is less sensitive

Pricing responses
Further work is usually required to achieve a satisfactory balance between profitability and
competitiveness. This may include consideration of other responses to experience such as:

- A review of the terms and conditions of the product in response to unsatisfactory claims or to
reduce expensive litigations
- A review of brokerage and commission arrangements including allowances for good quality, high
volumes producers
- Changes to underwriting procedures
- Changes to the risk classifications where an undue proportion of claim related to particular risk
categories
- Changes to claims management practices
- A review of discounts for wholesale arrangement which reduce the administrative costs of insurer.

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Defined benefit superannuation
The actuarial review
Defined benefit superannuation schemes provide benefits expressed in terms of members salaries
at or near retirement. These benefits are funded by regular employer and employee contributions.
While the employee contributions are defined, the employer contributions are reassessed at three-
yearly intervals through an actuarial review with the aim of building up sufficient assets to meet the
benefits as they fall due. This is in contrast with defined contribution funds where employer and
employee contributions are defined and the ultimate benefits is the accumulation of these
contributions with investment earnings.

For defined benefit funds, the employer contribution rate is affected by:

- The investment earnings achieved on the fund investment

- The salary increases received by fund members
- The incindence of early retirements, deaths, resignations, and transfer of members
- Insurance and management expenses of running the fund

The pace of funding

At one extreme, employer chould choose to fund the benefits for a new employee by putting aside
an amount equal to the present value of all future benefits for the employee. An other extreme is
fund the benefits when they fell due at the retirement of the employee. Intermediate approach
(benefits is funded by employer contributions set as a level percentage of salaries during members
employment) is usually chosen which provides for a more even charge to the profits of the employer
and which secures benefits for members progressively during their period of service.

There is a minimum level of funding established by regulations or generraly accepted practice (eg
funds may be sufficient to hold assets to cover the value of accrued past services)

Responses to the actuarial review

The main focus of th actuarial review is recommending employer contribution rates for the next
three years. Generally they will prefere stable contribution rates so that the numbers can be
confidently included in the business budgeting. Below are the steps to review the contribution rates

- Review future assumptions based on experience and future expectations

- Review the funding method and pace of funding
- Review the minimum funding level
- Recalculate the employer contributions rate based on the chosen assumptions and funding
method
- Consider the need for special contributions (to meet cashflow requirements or when the
funding level falls below or close to payment)

When investment returns are strong relative to salary increases, the employer can cease
contributions for ap period of time or even indefinitely (contribution holiday). There are also other
actions that can be considered following the review

- Changes to investment policy or investment manager

- Updating of or other changes to fund benefits
- Improvements in administration procedures
- Changes to the level of insurance of death and disablement benefits

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Recognising profit in insurance
Recognising profit
Profits are recognised more evenly over the life of a contract. Profit recognition is affected by the
past experience of the product and expectations for the future. The extreme methods are
recognising profit after the policy is expired, or recognising profit when the policy is issued as an
estimate basis of future profits with reasonable assumptions

Life insurance: margin on services

(NOTES: this section is an Australian context)

Life insurance profits are recognised in accordance with the Margin on Service (MoS) method.
Profit is recognised over the term of each group of policies as services are provided and risks
undertaken by the insurer. The factor used to recognise profit is called the profit carrier (eg risks
insurance such as life and disability insurance, the predominant service or risk is paying claims, so
profit is recognised over the term of each group of policies in proportion to the expected claims
payments for those policies)

General insurance: prudential margins

(NOTES: this section is an Australian context)

General insurance profits are recognised after settings aside prudential margins for outstanding
claims. The prudential margins are expressed in terms of the percentage likelihood that the claims
profitability will prove to be adequate. The Australian prudential standard is a 75% probability of
adequacy. Prudential standard is selected by the companies according to their risk profiles.

Capital and distribution of profit

Once profit has been determined for these portfolios, amounts must be set aside to meet the capital
requirements and the balance of profit is avalibale for distribution to shareholders. Capital
requirements includes both minimum regulatory requirements and any additional amounts to
provide safety margin.

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Participating life insurance

The origins of the actuarial profession

The industry used simple policies (eventhough economic, investment, and other experience is
changing) instead complex policies to cover every possible outcome and relied on actuarial
profession to formulate equitable methods of allocating the experience profits to the variation
interest groups

Participating policies
Participating policies are defined as life insurance policies which the company exercise some
discretion in allocating investment returns to the policies. The main categories of participating
policies are:

- Whole of life and endowment insurance policies, where investment returns are allocated by
means of sum insured increases (eg reversionary bonuses)
- Investment account policies, where investment returns are allocated by annual interest credits.

Unitised policies where the full investment return is passed to policyholders through unit pricing
are not generally participating policies although unitised with profits policies in the UK use the
mechanism of unit pricing to pass profits to policyholders.

Allocation and distribution of profit

As part of the annual actuarial review of a life insurance company, the actuary makes
recommendation about how investment and other experience profits are allocated and distributed
to participating policyholders. Allocation is used to describe the determination of the profits to be
allocated to each group while distribution refers to method used to pay out the allocated profit.
Sample of distribution (method) of allocated bonus are reversionary bonus, or reductions in next
year premium.

Allocation to profit
A first consideration in allocating profits is the legal requirements (e.g. min 80% profits is allocated
to participating policyholders and max 20% for shareholders). There are some interest group in
which the actuaries has a legal and professional responsibility to seek a fair and equitable
allocation:

- Shareholders and policyholders

- Par and Non-Par policyholders
- Different classes of policyholders in one statutory fund (e.g. by type of policy, by duration of
policy, by age of life insured)
- Different generations of policyholders
- Those who surrender and those who continue

Fair and equitable

In making an achieveable equity, the actuaries often have access to more detailed information and
analysis than others. It is important that actuaries provide good explanation of the process, and
seek solution which is practical to implement (there are costs of implementation). Some concepts
used to test equity include:

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 - Meeting reasonable expectations reasonable benefits are paid to policyholders having
regard to all circumstancesof their policies (e.g. change in economic conditions). Factors are
need to be considered in determine reasonable expectations include:
o Point of sale benefit illustration and other sales material (consistent with what was
promised allowing for the difference between actual and expected experience)
o Established company practice
o The policy terms and conditions
o The constitution of the company
o The general economic and business environment
- Fair return in relation to risks accepted
o Shareholders require returns to compensate for the capital provided and the
entrepreneurial risk in operating the business
o Participating policyholders require bonuses or other returns to compensate fo the
increased premiums they have paid
o Participating policyholders with benefit guarantees accept lesser risks than those
without guarantees
o Non-participating policyholders do not share in the experience of the business because
their benefits are contractual so they do not generally share in allocation and profit.
- Generational equity it is argued that subsidies between generations are fair if these are in
line with the reasonable expectations

Distribution of profits
Some factors to consider when set the amount and form of the distributions:

- Capital requirements which may limit the distribution of profits

- Competition
- Consistency with legal requirements and past practice
- Simplicity and practicality

Methods of distributions
Commonly used methods for distributiong profits (in Australia):

- Interest credits on investment account policies provide a smoothing of investment returns

over time by averaging returns over several years.
- Uniform reversionary bonus profits may be distributed by an addition to the sum insured
payable on death or maturity. It could be as a simple (% of sum insured each year), compound
(x% of sum insured plus accumulated bonus each year), super-compound (x% on sum insured
+ y% on accumulated bonus, y>x)
- Terminal bonuses percentage addition to the amount of claim, including reversionary
bonuses. The terminal bonuses method was developed to deal equitably with the more volatile
returns from equity investments.

Other methods of distributing profit is a cash dividend. In some countries, cash dividends are
accumulated in a separate account which attract interest but can be drawn down whenever there is
a need for cash. For non participating policies, there might also a profit share which is calculated as
some factors of premium paid less the claim paid.

Asset share methods

The asset share is an accumulation of the cash payments for a group of policyholders over the entire
lives of the policies using the actual experience over this period. The accumulation may use actual

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or smoothed investment returns with the choice being dictated by the purpose of the calculation
and by the companys bonus distribution philosophy.

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