ACTL4001-Notes HD CLEAR AND CONCISE PDF

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ACTL4001 NotesActuarial Control Cycle ATony ZhengApril 15, 2019Contents 1 Week 4: Chapter 8: Product Design Stage 1: Identify need for new product Develop a product strategy Stage 2: Develop Product Stage 3: Manufacture/Distribute product Stage 4: Gather and Monitor Experience 2 Week 5: Chapter 13: ...

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ACTL4001 Notes Actuarial Control Cycle A

Tony Zheng

April 15, 2019

Contents 1 Week 4: Chapter 8: Product Design Stage 1: Identify need for new product . . Develop a product strategy . . . . . . Stage 2: Develop Product . . . . . . . . . Stage 3: Manufacture/Distribute product . Stage 4: Gather and Monitor Experience .

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4 4 4 4 5 5

2 Week 5: Chapter 13: Pricing Environment . . . . . . . . . . . . 1. Product Design . . . . . . . . . 2. Price postulated . . . . . . . . . 3. Modelling . . . . . . . . . . . . . 4. Assumptions . . . . . . . . . . . 5. Expenses . . . . . . . . . . . . . 6. Profit objectives . . . . . . . . . 7. Profit testing . . . . . . . . . . . 8. Sensitivity tests . . . . . . . . . 9. Pricing report . . . . . . . . . . 10. Product monitoring . . . . . . 11. Pricing long-term commitments

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3 Week 6: Chapter 7: Regulation Sources of law . . . . . . . . . . . . . . . . . Levels of regulation . . . . . . . . . . . . . . Types of Law . . . . . . . . . . . . . . . . . Scope of laws that influence financial sector Taxation legislation . . . . . . . . . . . . . . Regulation of markets/companies . . . . . . Other objectives . . . . . . . . . . . . . . . Regulation of specific types of business . . . Prudential regulation . . . . . . . . . . . . . Arguments for Regulation . . . . . . . . . . Arguments against Regulation . . . . . . . . International Regulation . . . . . . . . . . . Core Principles . . . . . . . . . . . . . . . . Role of Actuary . . . . . . . . . . . . . . . .

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4 Week 7: Chapter Profit measurement Emergence of profit Profit versus value Appraisal values .

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16: Profit . . . . . . . . . . . . . . . . . . . . . . . . . . . .

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Appraisal value as profit measure . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

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5 Week 8: Chapter 2: Risk Management Frameworks Risk Management Framework (RMF) . . . . . . . . . . . . . Large financial services providers . . . . . . . . . . . . . . . What is risk? . . . . . . . . . . . . . . . . . . . . . . . . . . Types of Risk . . . . . . . . . . . . . . . . . . . . . . . . . . What is ERM? . . . . . . . . . . . . . . . . . . . . . . . . . Risk Management Process . . . . . . . . . . . . . . . . . . . Communicate and consult . . . . . . . . . . . . . . . . . . . Execution . . . . . . . . . . . . . . . . . . . . . . . . . . . . Risk management interests, responsibilities and governance .

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6 Week 9: Superannuation Context . . . . . . . . . . . Employee contributions . . . Access to Super . . . . . . . Taxes . . . . . . . . . . . . Super funds . . . . . . . . .

in Australia . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

7 Week 10: Chapter 11: Capital Reasons for capital . . . . . . . . . . . Need for capital, different perspectives FI without shareholders . . . . . . . . Risks and Capital needs in FI . . . . . Overall Company perspective . . . . .

Options, Futures and Risk Mgmt

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Week 4: Chapter 8: Product Design Stage 1: Identify need for new product • Innovation- product is unique, Result from insightful analysis of market • Regulation/tax law changes - can create new opportunity • Entry into new market/distribution channel - copy competitors due to lack of experience but identify some distribution channel which is profitable • Updating for Experience • Market research

Develop a product strategy • Discuss how product fits company’s strategic plan • Specific market targeted • Method of distributing product - critical, product experience could be impacted • Competitive advantage of company • Develop Sales and profit expectation of product • Risks associated with product/ways to mitigate risks • Resources necessary for successful products and evaluate company capacity - Capital requirements, Company experience

Stage 2: Develop Product • Project Management ⋄ Objective/expectation of project ⋄ Financial implications of project ⋄ Time-line, responsibility and communication of project • Design features to control risks - Product designed to mitigate risk • Competition, marketplace and pricing process ⋄ Pricing Product ⋄ Competition and marketplace • Stakeholders expectations

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STAGE 3: MANUFACTURE/DISTRIBUTE PRODUCT

ACTL4001 NOTES

⋄ Provider - Different stakeholders e.g. Board, Employees. Most have aligned interests but there may be conflicts of interest ⋄ Consumers - Expects product to deliver ⋄ Retailers- Expects product to be competitive ⋄ Regulators • Deciding whether to launch product depends on company to make conscious decision for their objectives.

Stage 3: Manufacture/Distribute product • Distributing product to clients ⋄ Contract and Sales Material - Contract - Illustration/representation on sale - Company philosophy - Actual experience with mortality/investments - Historical practice of company - Standard of practice in industry ⋄ Marketing - depends on distribution channel, advantage can come from - Superior product, lower price, more coverage, etc - Higher compensation to broker - Superior service - Superior financial strength/reputation • Risk selection - tradeoff between risks to take and idea everyone should be in it • Administration of product • Asset-Liability Management

Stage 4: Gather and Monitor Experience Lastly, we need to gather and monitor experience. Extremely important to make adjustments to significant deviations and identify the need for new products.

Actuarial Control Cycle A

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Week 5: Chapter 13: Pricing Environment • Pricing objectives - Competitiveness/Profitability • Stakeholders - Owners, Sales intermediaries, Customers, Government, regulators, employees and reinsurers.

1. Product Design Depending on stakeholder, product design is benefit provided by product, some issues to think about - Marketing department can’t meet sales goals - Too many competitors - Price competitors charging will not result in adequate profit

2. Price postulated • Setting/testing price - Cost-plus process, or simply take 95% of market price • Impact of prices/commission on sales

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3. MODELLING

ACTL4001 NOTES

3. Modelling One simple model to price profits is Profits = Premiums − Commission − Expenses − Claims − Change in reserves + interest Distributable earnings are defined as Profits minus change in target surplus

4. Assumptions include mortality, morbidity, incidence rates, claim amount distributions and per unit expenses, etc 1. Identify the need for an assumption, why its relevant. 2. Obtain relevant data, best data generally comes from a study on similar products. A margin is a change to an assumption that considers risk that an assumption is worse than expected. 1. Each assumption can be adjusted individually by margin - issue is total margin might be too big, making it too uncompetitive 2. One single margin added to entire pricing model- Should reflect how risky product is

5. Expenses • Fixed - Overhead • Variable - As policies sold increases • Semi-variable - Salary Some approaches • Marginal basis - measures how change in number of policies changes total expenses of business. • Fully allocated basis - allows for all profits of company to be allocated to various products/services.

6. Profit objectives • New business strain - at sale, product needs to cover expenses, reserves and target surplus Some measures include • Profit margin - PV of profits divided by premiums. Important assumption is rate used • Internal rate of return the rate such that PV is 0 • Return on capital is rate used to find PV of initial amount required to establish target surplus

7. Profit testing is using pricing model to measure expected profit vs profit objectives. Actuarial Control Cycle A

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ACTL4001 NOTES

8. SENSITIVITY TESTS

8. Sensitivity tests examine the impact of changing assumptions. Alternatives • Based on past experience, testing sensitivity range at a 95% confidence interval around mean. • Story behind sensitivity that explains why assumption might be different Test for plausible adverse scenarios such as stock market crash/recession.

9. Pricing report well-written report describes product design, recommended prices, key assumptions and profitability along with if objectives are met and what risks there are. Proper discussion of sensitivity test, could then monitor.

10. Product monitoring Actual vs expected and monitor results, change if necessary. Different products need monitoring at different intervals.

11. Pricing long-term commitments Different from pricing most insurance products, primary goal is to ensure expected future benefits equates to benefits and expenses to be provided. E.g. defined benefit schemes. Pricing is necessary to determine contributions needed. In general funding methods need to satisfy member benefits by retirement, fund’s asset should equal/exceed minimum benefits payable. Generally funding comes under 4 groups: • PAYG (Pay as you go) - do not fund in advance but pay as requires, common in public sector • Accrued benefits - fund PV of benefits which have accrued over time ⋄ Projected Unit Credit Method: requires contribution rate comprises of 2 parts: value of future benefits payable in respect of service accrued over year and one year’s amortization of difference between value of future benefits payable and the assets • Projected benefits - fund PV of all future benefit payments and expenses ⋄ Aggregate method is common, contribution rate is calculated as value of all future benefits payable less assets held divided by value of all future salary payments to existing member. • Initial funding - fund all benefits/expenses at beginning (large lump sum) Typically recalculated at regular intervals- every one to three years. Contribution rate should be PV(Contributions) = PV(benefits) + PV(expenses) − assets Projected unit credit method contributions generally start at a lower rate but increases as member’s age increases until it exceeds aggregate method (which is fixed percentage of salary). Page 8 of 21

Actuarial Control Cycle A

Week 6: Chapter 7: Regulation Sources of law Actuaries need to be familiar with law for their work, to interpret soundly and understand.

Levels of regulation • Primary legislation -under authority of constitution of jurisdiction, very detailed • Subsidiary legislation - standards extend beyond the Act itself and may have the force of law. • Court decisions and precedent - for future cases of similar nature • Self-regulatory organizations such as industry complaints-handling operations, APRA

Types of Law • Criminal law relating to particular crimes against ”the people” or the state. • Civil law, by contrast, provide compensation through payment of damages to party harmed • Equity law where one party can restrict/force action of another

Scope of laws that influence financial sector • Operation of company → corporate governance, accounting standards, financial reporting, etc • Maintaining competition in markets • Selling products, laws applying to agents/brokers, advisors • Conduct of business with customers • Tax, duties, levies • Fiduciary, trustee-related obligations, e.g. Professionals like actuaries

Taxation legislation Tax is used by governments to raise revenues to meet services/objectives.

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ACTL4001 NOTES

REGULATION OF MARKETS/COMPANIES

Regulation of markets/companies Often argued that regulation is there to protect failure of companies, four main sources • Anti-competitive behavior- some products can be compulsory (CTP) and the market entry barrier is high, regulation needed to provide mobility and enhance benefits for the consumers. This is a type of Prudential regulation. • Market misconduct ⋄ Primary market- selling new financial securities are subject to market disclosure rules ⋄ Secondary market- regulated to minimize market manipulation and fraud • Asymmetric information - or using technical language • Systematic instability- loss of confidence in sector as whole could be contagious

Other objectives ⋄ Favor local companies at expense of foreign-owned companies ⋄ Encourage growth of strong financial industry in nation ⋄ Strengthen local capital markets ⋄ Control currency movements ⋄ Ensure government debt can be financed ⋄ Integrate overall structure of social security

Regulation of specific types of business Some types don’t rely on competitive forces such as compulsory products like CTP, workers compensation. Other such as health insurance has risk equalization and set premiums.

Prudential regulation means regulation that tries to ensure regulated institutions operate soundly, reducing probability of failure and minimise loss if failure does occur. Regular reporting necessary, Some tools include: • Requirements on corporate governance • Fitness and propriety of owners, shareholders and managers • Accounting standards • Quality/Quantity of capital • Level of disclosure • Restrictions on corporate structure

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Actuarial Control Cycle A

ARGUMENTS FOR REGULATION

ACTL4001 NOTES

Arguments for Regulation Disclosure seems to solve many issues but by itself it is not accepted and needs regulation. • Effectiveness of disclosure depends on consumers/investors power to act on their observations • Operational risks, IT failures are difficult to address • Full disclosure is filled with too much technical information, requires lots of stamina to read/understand • Disclosure can be too late • Disclosure can lead to ”flight to quality”, that is people perceive risk too high for a FI and move to another

Arguments against Regulation • Inflexibility, Cost, Unforeseen implications • Reduced care/compliance orientation • Market interference introduces inefficiency • A rule may be in force even if it is no longer useful anymore There is always a balance between market disclosure and specific regulation.

International Regulation Longest standing is Committee on Banking Supervision at Bank of International Settlements (BIS) or Basel Committee. There are many others too. These organization produce core principles, standards and guidance as well as research and developments. They provide international benchmarks on prudent risk management, capital and corporate governance.

Core Principles • Establish supervisory authority that has operational and...