From the Examination Committee:

Testing at a Higher Cognitive Level

The Examination Committee has released three exam questions that were written for inclusion on the upcoming Spring 2012 examinations but were set aside for educational purposes. As previously announced, the Casualty Actuarial Society Board of Directors has charged the Examination Committee with transitioning more questions over time to correspond to higher levels of Blooms Taxonomy. For background on this initiative, please refer to the Future Fellows articles from December 2010 and December 2011. One example question with higher Blooms levels from each of the Spring 2012 Exams 5, 7, and 9 is included here, along with a sample answer, to demonstrate the kinds of questions candidates can expect to see on the exams and the type of responses that are expected for these types of questions. Note that we are transitioning to higher cognitive levels. Even after the transition is complete, not all questions will test at higher levels. Note that the sample solutions provided here are intended only to help candidates better understand the level of mastery they must demonstrate on higher cognitive level questions. Other full credit responses could exist that are based on different methods or that demonstrate the same level of cognitive ability in a different or more succinct manner. Further note that the questions here are without point values as they were not included with the finalization of the actual Spring 2012 examinations; however, these questions, relative to others on an individual exam, would be of higher-than-average point value. The Examination Committee hopes this proves helpful in providing insight into what higher-level Blooms Taxonomy questions look like and the kinds of responses that will earn maximum credit.

From Exam 5: Given the following information: Multivariate Results Impact of All Indicated Rating Plan Changes 4% -3% 0% 7% 0% # of policies cancelled at renewal in 2011 380 2,880 5,535 2,745 11,540 Total number of potential renewal policies in 2011 4,500 29,100 44,000 11,500 89,100

Deductible Full coverage $250 $500 $1,000 Total

Current Relativity 1.20 1.10 1.00 0.90

Indicated Relativity 1.25 0.99 1.00 0.98

Deductible Full coverage $250 $500 $1,000 Total

Policies as of Dec. 31 2010 5,000 30,000 45,000 12,000 92,000

% Policy Growth in 2011 302% -1% -2% -17% 13%

Total number of quotes in 2011 43,000 10,000 20,000 7,000 80,000

Number of accepted quotes in 2011 15,480 3,200 6,000 1,050 25,730

The Chief Underwriter informs the Actuary that all deductibles are available for new businesses. However, the Chief Underwriter informs the Actuary that the $1,000 deductible is mandatory for risks with a high frequency of claims in the past 5 years. The Actuary is also aware that a marketing campaign has been launched in the summer of 2011 that promotes the zero-deductible policy (i.e., the full coverage deductible). The company is operating in a deregulated free market. Fully justify an adequate differential for each deductible by assessing additional considerations and constraints that the Chief Underwriter should consider.

SOLUTION FOR EXAM 5 QUESTION Many selections are valid award points if the differentials are adequately justified and logical. Discussion of constraints should be discussed for each deductible: that is marketing constraints and operational constraint and the underwriting context. Discussion: Full Coverage: (potential elements of an answer) The marketing campaign generated a great increase in the demand for that deductible. There is an impressive 301.6% policy growth for that category. The category is competitive since the close ratio is fairly high at 36%. The experience used for the rating analysis was much sparser (only 5000 policies at the end of 2010) and the new business that comes in is much different from the past experience. Therefore, it would be prudent to select a differential that is not too low with respect to the indicated differential, especially with the important policy growth one wants to make sure that the category is correctly rated. Furthermore, since the close ratio is very high, it would be easy to implement a higher differential without hurting the competitive position of the company. Proposition: anything from (1.26 to 1.35). No change to differential could also be accepted with an adequate justification. $250 (potential answer) One of the major problems with the indicated differential here is that it is lower than the $500 deductible differential. Hence, in a sound insurance program, the premium should increase when the deductible is lower, not the opposite. The indicated differential then has to be modified for that. On the competitive side, the close ratio is similar to the average for the total of the book of business; there is not a problem on this side. The retention ratio is also good. However, there is negative policy growth, probably due to the switch to the zero-deductible policy. Furthermore, the differential should not be too close to 1.0 since there must be an incentive to switch from the $250 deductible to the $500 deductible. If the rebate is too small, the insured will not choose a higher deductible. Acceptable selection: (1.03 to 1.15). $500 (potential answer) This is the base level hence the selected differential will be 1.0. Looking however at the different ratios, we can see that the company is a bit less competitive for this deductible. The close ratio is lower than for other deductible ($1000 excepted). The retention ratio is below average at 87.4% and there is a negative policy growth. The company should perhaps monitor this category in the coming months to make sure there is no problem. Acceptable selection: 1.00

$1000 (potential answer) Here one must be prudent when analyzing the information for this deductible the fact that all high frequency risks have to select a $1000 deductible on the policy makes the competitive indicators highly biased. Firstly, there is a good chance that the close ratio is low due to the frustration some potential clients may face when being forced to take a higher deductible. Secondly, the retention ratio might be low because some insured may find less strict underwriting rules at some competitors. The rating differential is also influenced by the fact that the percentage of high-risk policies is fairly high. One may wonder if the models other rating variables are not predictive enough for the high-risk policies. However, not all clients that select the $1000 deductible are high-frequency high-risk policies. The actuary perhaps wants to select a deductible that gives a higher rebate in order to encourage clients to select a higher deductible. Acceptable selection: (0.90 to 0.98) Many other selections are acceptable if well explained (this goes for all the justifications).

From Exam 7:

A multivariate Normal distribution is used for a companys internal model to calculate its capital requirement. The model is specified by its mean vector and covariance matrix:

Where i,j is the correlation between the ith and the jth risk components, and j is the standard deviation of the jth component. j is used as the risk measure and the indicated capital requirement is a multiple of the standard deviation.

The capital requirement of the aggregate risk can be written as

a. Evaluate this methodology in terms of two potential errors and propose two ways to compensate the distortions. b. Suggest one way this model can be improved and provide support for your suggestion.

SOLUTION FOR EXAM 7 QUESTION

a. 1. When the Normal model is used as a base-line model, the true distribution errors can occur. The true probability distributions associated with particular risks may be quite different from the Normal distribution. For example, the tail distribution could be heavier than that of the Normal distribution. 2. The marginal distribution of the various risks are combined into a multivariate distribution, the linear correlation used in the Normal distribution may not be well suited to combining interactions in the extreme tails of the distribution. To compensate the distortions, 1. A supervisory institute can require a multiple (e.g. 150%) of the capital indicated by using a specific model, providing a cushion for model error. 2. The model can introduce conservatism into assumptions, parameters, and correlations.

b. (various keys are acceptable) 1. Wang Transform. For a risk with a loss distribution F(x), the Wang Transform gives a transformed distribution that is another Normal distribution but with the mean replaced by and standard deviation unchanged. This would extend standard deviation for non-Normal risks. 2. Linear Approximation. If the actual mix of risks is close enough to the representative mix, the capital requirement is approximated by a factorbased formula where the factors are derived from the derivatives of the capital function at the target risk mix. 3. Quadratic Approximation. It allows for any risk measure and any distribution. 4. Use Copula to model dependencies. In a multivariate Normal setting, the are asymptotically independent if the linear correlations are less than one. Use of Copula can allow dependencies being modeled on a deeper level than linear correlation.

From Exam 9:

A potential insurance customer whose house has a replacement value of $200,000 wants to insure it for one year against the event of a total loss. The insurer determines that the probability of such a loss is 0.5%., and that annual expenses of the policy would be $250. The bank will lend, at a 5% annual rate, the capital needed to hold for one year to insure the house against total loss. Assume the following: The policyholder is required to pay a single, up-front premium for one year of coverage. The current investment income yield rate is 4%. Investment income is earned at the end of the year. The likelihood of loss is uniform throughout the year. The insurers expenses are incurred at the beginning of each year. Only supporting capital is invested; all other assets earn no investment income. Ignore taxes. a. Calculate the premium that the insurer would need to charge to cover the cost of the capital hurdle rate. b. Contrast the economic benefit to the customer of purchasing this insurance versus self-insurance for one year, assuming the company charges the premium calculated in part a., above. c. Discuss what happens to the economic value of self-insurance to the customer as the projected time period becomes longer than one year. d. Justify the customer's decision to purchase insurance.

SOLUTION FOR EXAM 9 QUESTION A. The insurer would collect premium P, pay $250 of expense, and commit $200,000 of capital at T=0, pay expected losses of $1,000 at T=0.5, and release capital of $200,000 and collect investment income of $8,000 (=$200,000*4%) at T=1. The IRR equation would look as follows: 0 = P - 200,250 $1,000/(1.05)^.5 + 208,000/(1.05) Solve for P to get $3,131 B. If the customer purchases insurance, she will pay $3,131 in premium and receive $1,000 (=$200,000*0.05%) in expected loss savings for a net benefit of -$2,131 (=$1,000-$3,131) If the customer does not purchase insurance, she could invest the money at a 4% yield that she would have used to pay the premium. Her expected loss would be $1,000 (=$200,000*0.05%). Thus, the economic benefit would be $3,131*1.04 - $1,000 = $2,256. A candidate may use discounting in their answer, which is acceptable, but not required. The point is to show that buying insurance is an economic loss. C. Use a two-year horizon as an example. The probability of no loss in two years is 99.5%*99.5% = 99% (Thus a 1% chance of loss). Therefore, the expected loss to Sam over two years is $2,000 (=$200,000*1%). The customer could invest the first years premium ($3,131) for two years and the second years premium ($3,131) for one year. In total, the customer's economic benefit is 3,131*1.04^2 + 3,131*1.04 2,000 = $4,643. Using a time-horizon of three years shows that the trend continues. The probability of loss is equal to 1 99.5%^3 = 1.5%. In total, the customer's economic benefit is 3,131*1.04^3 + 3,131*1.04^2 + 3,131*1.04 (200,000*1.5%) = $7,039. The longer the time horizon, the more beneficial self-insurance is economically. Again, a candidate may use discounting in their answer, which is acceptable, but not required. The point here is to show that over a longer time horizon, purchasing insurance gets economically worse. D. There is always a loss of economic efficiency when additional parties are involved because of additional expenses and profits. People do not buy insurance for the economic gain, but rather for the non-economic benefits peace of mind, security, stability. Insurance also allows people to not have to try to obtain enough capital to be able to replace their insured property.