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40 EXAM 7- UNITED STATES, SPRING, SECTION II SECTION I, QUESTIONS 1-26, MULTIPLE CHOICE QUESTIONS 1. E 2. Invalid 3. C 4. A 5. D 6. E 7. C 8. E 9. C 10. D 11. B 12. B 13. D 14. D 15. C 16. A 17. B 18. C 19. E 20. B 21. D 22. D 23. B 24. C 25. D 26. A 27. C 28. B

41 EXAM 7 US QUESTION # 29 (A.) Alice is 25% responsible, so pays 25% (20,000) = 5,000 to Bob. Bob is 75% responsible, so pays 75% (10,000) = 7,500 to Alice. (B.) Alice is the only person who can recover since she was less than half at fault. Bob owes 75% (10,000) = 7,500 to Alice. (C.) In contributory negligence, there is no recovery if you are at all at fault. Therefore, neither pays anything to the other. QUESTION # 30 (A.) Pure no-fault does not deter risky behavior. This system does not consider who is at fault. Regardless of who is at fault the injured party s insurance pays for their damages. The tort system puts the blame and responsibility to pay for damages where it belongs: on the at-fault party. Payment for damages is either received directly from the at-fault party or from his/her insurance. If future premium is based on past experience, one would expect the at-fault party s premium to increase, which would be an incentive to avoid future risky behavior. (B.) Pure no-fault results in speedy claim settlement. The time needed to file, investigate and argue suits is eliminated. Whereas the tort system lengthens the claim settlement period, to include time to investigate, file and argue responsibility and payment. QUESTION # 31 (A.) The market conditions of the P & C Insurance industry are inconsistent with collusion. Market conditions such as low barriers to entry, low concentration levels, & relatively constant costs tend to indicate competitive conditions. (B.) The heterogeneity of prices in the P & C industry is inconsistent with price fixing. Lack of any truly consistent pricing among insurers would discount claims of price fixing.

42 QUESTION # 32 QUESTION # 33 Insurers would increase prices for all insureds (become more conservative in rating) Insurers would institute complicated risk classifications (using u/w guidelines) to make insurance very expensive for high-risk insureds. (1.) May be regulatory restraints such as forcing the insurer to leave all lines of business in the state. (2.) Loss of economies of scope brought by selling multiple lines of business in the state. QUESTION # 34 (A.) HUD argued that insurers can not use sex, age, race, family status for rating unless it was supported by a compelling and sound actuarial analysis. (B.) i. Lack of understanding of urban risk factors ii. Inadequate rates. (C.) Actuaries should ensure that everyone involved understands the economics of the risk selection, classification and pricing processes. They should also work to develop better risk management tools. QUESTION # 35 (A.) An allowance could be chosen by judgment, or by a statistical analysis of variance in return-on-equity (ROE). In New York, the reasonable ROE is 18% and the allowance for deviation is 3%. (B.) No, because products liability is a long-tail line and is probably subject to greater variation over time. A greater allowance would be justified. (C.) TYPE I and TYPE II (1.) Long-run profits are excessive, but short-run profits are determined to be reasonable. (2.) Short-run profits are determined to be excessive, but long-run profits are reasonable.

43 QUESTION # 36 (A.) (1.) Raise more capital to increase policyholders surplus. (2.) Cease writing certain lines of business. (3.) Reduce dividends. (4.) Improve reinsurance coverage. (B.) If the public learns the company is in trouble they may take their business elsewhere, guaranteeing that the company will not survive. QUESTION # 37 (A.) Failing ratios on the IRIS tests provides regulators an early warning of potential financial problems of an insurer. The regulators prioritize the NAIC zone exams for companies with more failing tests, and which tests fails indicates where further to investigate. (B.) The ratio of the insurer s Adjusted Surplus to the Authorized control level RBL determines the regulator s response. (Adjusted Surplus)/ (All RBC) Regulator Response 150% - 200% - Company Action Level company submits plans to increase capital & risks to capital. 100% - 150% - Company submits plan as above; regulation may take some corrective action. 70% - 100% - Regulator is authorized to (may) take control. 70% - Regulator is authorized to (must) take control. QUESTION # 38 (A.) Could increase size of residual market; if ins companies not allowed to set appropriate rate, they will refuse to sell policies, forcing substandard customers into the residual market. (B.) Insurer profits over long term not affected since ins companies won t sell policies w/out a proper return.

44 QUESTION # 39 (i.) Regulators/states thought less regulation would help the affordability, availability, and particularly lower what were high rates. (ii.) Regulators/states became more interested in solvency monitoring as solvency tools and effectiveness increased. Rate regulation was not seen as important in maintaining solvency. (iii.) Judgments and such actions of congressional committees (particularly the O Mahoney committee) called for/ affirmed the practice of rate deviations; the importance of bureau roles subsequently diminished. QUESTION # 40 (A.) A better means to protect consumers against high cost insurers would be better insurance consumer information. Prior approval restrictions are an inefficient means of obtaining this protection as it adds other costs to the insurance system. (B.) Government could provide better consumer information on insurance pricing; through public service ads, websites, consumer bulletins, media releases, or could require the insurers to provide this information through a sort of truth-in-selling clause. QUESTION # 41 (A.) To avoid price war and competition. (B.) NAIC working group concluded the rating organization should be prohibited from preparing and distributing final rates. Insurers should be forced to develop their own expense and profit loading. 19 states brought suit against ISO and a group of insurers and re-insurers charging they violate state and federal anti-trust laws.

45 QUESTION # 42 (A.) The ruling was that the insurance business was interstate commerce and, as such, was not exempt from the federal anti-trust laws, such as: the Sherman Act, the Clayton Act, the Robinson-Patman Act, and the Federal Trade Commission Act, all of which prohibited collusion to monopolize market; unfair trade practices and actions like boycott, coercion, and tie-in sales. The impact on the insurance industry was that: (1.) Insurance became a subject of a federal regulation and (2.) The rates could not be set by bureaus or other rating organizations because that would be anti-trust action of setting rates in concert. (B.) Provision 1: it is in public interest for the insurance business to be regulated by states; Impact: states could continue to regulate and TAX (show me the money!) insurance business; Provision 2: Sherman, Clayton, Robinson-Patman, FTC acts did not apply as long as states regulated the insurance business in order to maintain antitrust spirit and competition among insurers. Impact: The rates could be provided by bureaus, given that virtually all states adopted the prior approval laws to regulate those rates. (C.) One benefit can be that national insurers or insurers with writings in more than 1 state will see more consistency in regulation as opposed to having to comply with each state s specific laws and requirements. This can bring some expenses down.

46 QUESTION # 43 (A.) Data indicates that for US insurers subject to RBC, the RBC charge has averaged about 50% of the carrying value. (B.) The RBC charge for the subsidiary could be passed up to the parent. (C.) The charge is different because companies outside U.S. have different annual filing requirements. It would be difficult to calculate their RBC charge. (D.) FOR Assessing the financial status of an alien insurer is more difficult since they are not subject to the same regulatory requirements as US subsidiaries. This fact increases the risk of investing in Alien subsidiaries and therefore should require a higher RBC charge. AGAINST It may discourage investment in Alien subsidiaries which reduces the diversity of the portfolio. Reduced diversity produces increased risk of a large loss due to one event. QUESTION # 44 (1.) The collapse of the WTC may not be indicative of all terror attacks. There may be many possible frequencies and/or severities for other types of attacks. This would mean that the model is not representative of terrorist risk in general. (2.) WTC was located in NYC where costs are generally higher than country wide costs are. Also, concentrations of people were probably higher than average countrywide. This would mean that the model is really more representative of terror in a major metropolitan area than terror countrywide. QUESTION # 45 (1.) If insurance companies manipulate model results in a way that increases rates for public, that specific company will lose better risks to competitors who did not manipulate results. (2.) If insurance companies manipulate model results and overestimate losses, this puts downward pressure on company s earnings and increases the need of reinsurance and the cost of such reinsurance.

47 QUESTION # 46 (A.) If insurers are not providing a certain coverage, there is probably a reason. If the insurance community feels a risk is uninsurable or is unwilling to meet certain demands, maybe the government should try to find out what their reasons are and see if there is a way to make the risk insurable instead of just taking over and losing money. (B.) Forcing people to buy insurance is a separate issue. You can force them to buy something without having to make them buy it from the government. (C.) Governments are not necessarily more efficient. It may seem that way since they can eliminate costs such as commissions, but there are many costs that aren t being accounted for, so it is unclear if they really are being more efficient. (D.) Collateral social purposes are more appropriate for a welfare program than insurance. If you want to offer young or bad drivers a subsidy, then give them one or set up a welfare plan for old people. It doesn t require governments to provide insurance. QUESTION # 47 (A.) Reinsurance Facility When a risk applies to an insurer the insurer can choose to accept that risk or send it to the reinsurance facility, but still service the policy. JUA a risk applies to the JUA and is serviced by one of the servicing carriers. (B.) Reinsurance Facility The sharing of profit or loss is done on a formula basis. JUA the sharing of profit or loss is done based on the voluntary market share of insurers. (C.) Reinsurance Facility Insureds are not aware that they are in the residual market, since the company they applied to services the policy whether or not it was sent to the reinsurance facility. JUA they are aware, since they apply for insurance in the JUA.

48 QUESTION # 48 (A.) Under current cost financing, current workers make contributions to the pension plan which are paid out to current pension beneficiaries. There may be a small contingency fund for short term imbalances of contributions and payments, but reserves of any substantial size are not built up. Upon plan termination, workers who contributed to the plan can not receive future benefits because there is no source of revenue to fund benefits any longer. (B.) Under full reserve financing, workers contribute to a plan which builds up reserves and earns interest to the point necessary to provide future pension benefits to that worker. Upon plan termination, the amount paid into the reserves and interest will be available to fund the pension benefits of the contributors. QUESTION # 49 (A.) Social insurance is financed through premium payments mainly. Social welfare is financed through general funds from government. (B.) Social Security financed through payroll taxes, interest earned on trust funds and taxes paid on monthly benefits. Unemployment Insurance funded through premium paid by employers. QUESTION # 50 (A.) Payroll taxes on employer, employee and self-employed (B.) Major financing = premiums payment by insured Other = government revenue

49 QUESTION # 51 (A.) (1.) National Flood Insurance write your own program. (2.) OASDI competes with private insurance. (3.) Unemployment insurance (with cooperation of states). (B.) (1.) State government enacts statutes and/or legislation mandating workers compensation insurance which private insurers then provide. (2.) In some states there are competitive state funds competing with private insurers. (3.) In some states there are exclusive state funds. QUESTION # 52 A company could use restrictive underwriting criteria to write only the best (lowest-cost) risks. It could then offer these customers very low rates. Alternatively, a company could target a very high-risk market segment, such as youthful males with accidents. While this would require much higher rates, the company could still be competitive with other companies seeking this business. QUESTION # 53 (A.) Statutory required capital - High statutory requirements (RBC) provide sufficient protection and leads to greater capital than for probability of ruin (little catastrophe exposure). (B.) Probability of ruin reserve margins are slight, risk based capital requirements are low, but catastrophe exposure is high.

50 QUESTION # 54 (A.) Schedule F develops the provision for reinsurance as a prospective measure of uncollectible reinsurance. The provision is formula driven and may not be an accurate estimate of uncollectibility, as it tends to be biased upward. (conservative) (B.) The Actuary completing the SAO should consult with management about expected collectibility problems, consult industry ratings, and review Schedule F. The SAO should give a prospective measure of uncollectible reinsurance in the actuary s opinion and the extent the uncollectible amounts are accounted for in reserve estimates. (C.) Example 1: Note 17 is a retrospective measure of reinsurance collectibility and gives the amounts written off during the calendar year. The amounts should be broken down into their components, ie. Loss, LAE, UEPR Example 2:Does not address uncollectible reinsurance. (Chairman s Note: We gave credit to candidates who knew that the old Note 17 was renumbered in the 2004 AS.)

51 QUESTION # 55 Balance Sheet: The Cash asset decreased by $45 milllion. The Loss Reserve did not change. A write-in contra-liability was established for $50 million. This is a contra-liability called Retroactive Reinsurance Ceded or Assumed. It decreased total liabilities by $50 million. The $5M of surplus gain is restricted as a special surplus write-in item. It is not part of unassigned funds. Income Statement: The $5 million gain is a write-in for Other Income. It does affect Underwriting Income. Balance Sheet: The Cash asset increases by $45 million. Loss Reserves do not change. A write-in liability, Retroactive Reinsurance Ceded or Assumed is setup for $50 million. This increases total liabilities. Surplus decreases by $5 million. Income Statement: The $5 million loss is a write-in for Other Income. It does not affect Underwriting Income. QUESTION # 56 The note requires that total L + LAE reserves at the beginning and end of each year be displayed along with loss + LAE incurred, on a calendar year basis, and paid during the year. These are reported both gross and net for the most recent 5 calendar years. Year Reserve Beginning Incurred During Paid During Reserve Ending , , , ,000 10, , ,000 1,050, ,000 1,350, ,350, , ,000 1,400, ,400,000 (150,000) 250,000 1,000, ,000,000 1,160, ,000 1,300, ,300,000 20,000 20,000 1,300, ,300,000 (130,000) 20,000 1,150, ,150,000 (30,000) 20,000 1,100,000 The Annual Statement Note will only show the years 1999 through 2003 (5 years). In this problem we show only gross because there is no reinsurance.

52 QUESTION # 57 (A.) Bonds Amortization could be above market value. Reinsurance recoverable on Paid Reinsurer quality could be questionable, or could dispute. (B.) Schedule D has extensive info on Bond Portfolio, by quality + duration. Schedule F parts 3 and 4 has breakdown of reinsurance, Notes provide additional info on potential collection problems (C.) ABC shows 15,000 Loss Reserves LAE Reserves = 20,000. These Reserves are supported by 11,500 in surplus. ABC might be in need of increasing surplus to support any adverse development on the reported reserves. XYZ shows 10,000 Loss Reserves LAE Reserves = 11,000. These reserves are supported by 12,500 of surplus. XYZ appears to be in a relatively better leverage position than does ABC with respect to reserves. (D.) XYZ uses unauthorized (or slow) reinsurers, but the F penalty is still less than half of surplus. ABC s are current (they have some, because of the $5 K recoverable). ABC has substantial funds on deposit with its insured, about equal to its surplus, and about half of its reserves - that could be a problem, especially if the funds aren t held by the companies responsible for the reserves (if they do match, we have a stronger case to offset). (E.) I would have to say that XYZ has the stronger balance sheet since it has more invested assets, it is leveraged better, and since its PHS is greater than that of ABC. The reinsurance security may not be as strong with XYZ, but the Schedule F Penalty should account for this.

53 QUESTION # 58 (A.) (1.) (2.) (3.) Effect on Statutory Income 0.05M + (2M- 1.95M) = M + (2M-0.725M) = M M + (2M-OM) = M Effect on Reserve Disc. Adjustment 2002 Disc. (2M)(1-.82) =0.36M 2003 Disc. (1.95M)(1-.8) =0.39M Change = +0.03M 2003 Disc. (1.95M)(1-.8)=.39M remove discount before determining IRS discount Charge = +0.03M 2003 Disc: 0 Charge M Effect on Regular Taxable Income M = + $30, M M = + $1.255M 1.225M-0.36M =+$865,000 (B.) M * *.8 = +.03 M 2 M * = M * TT = M (Chairman s Note: We did not receive any answers on Part C that received full credit, so I decided to include the following sample answer for this part: The answer for option 2 in b. is clearly the correct one. In 2002, Micro was allowed a deduction for incurred loss of 2.0*.82=1.64M. In 2003, they are stating that they only need a deduction for The difference between these two numbers is 0.865; the additional income that they need to pay tax on. In a. stat income for 2003 would reflect the full change in discount of Since the IRS made Micro pay tax on discount in 2002 of.36 (2*.18), this needs to be credited = )

54 QUESTION # 59 All companies would appear weaker to regulators since surplus would decrease while the reserving risk charge would increase. However, the actual strength of the companies would not change. It would therefore make sense to lower the authorized control level from 50% of the risk-based capital charge. QUESTION # 60 (A.) (1.) Agent s balances > 90 days overdue. (2.) The chair I am currently sitting on. (B.) - Provision for reinsurance (schedule F penalty). - Unrealized capital gains. QUESTION # 61 (A.) Return on capital Capital embedded in undiscounted loss reserves, gross unearned premium reserves and capital tied up in risk based capital requirement. (B.) When economic theory of capital exceeded the capital based on statutory standards.

55 QUESTION # 62 (A.) Avg case o/s per open clm = Pt 2- Pt 3 Pt 4 Pt 5 (o/s clms) Avg paid per reptd clm = Pt 3/ PE 5 (clms reptd) (B.) PMT patterns The pmt pattern has changed for for at least the latest 3 accident years shown. There is a consistent pattern for each year and then a small increase in the factor in the latest calendar year. This could be due to a change in claims department practices. Case Reserves Yes the data support management s contention that case reserves are stronger. Each accident year s average reserve for 2003 has increased quite significantly from other accident years as of the same valuation. Ultimate Loss & DCC It is possible that ultimate losses & DCC have remained unchanged. The claims dept could have made a conscious effort to close out small claims, making all the average higher but not increasing the amounts of the claims.

56 QUESTION # 63 (A.) Assume start at payment date of claim by P Overdue 1-30 days days Nov M > >120 July M total payments due = = 19M total overdue = = 14.5M 14.5/19 by 120 days = 76.3 % (B.) payments ovedue 90 days = 2.5M total payments = 2.5M + 4.5M = 7M payments last 90 days = 3M % = 2.5M = 25% > 20% 7M + 3M slow-paying (C.) total recoverables = 12M + 2.5M + 4.5M + 3.5M + 8M = 30.5 M security - 20 M 10.5 M total overdue and in dispute = 12M + 2.5M = 14.5M payments 20% x max (10.5M, 14.5M) = 2.9M QUESTION # 64 (1.) Net earned premium 100,000 (2.) Net loss incurred -70,000 (3.) Net LAE incurred -12,000 (4.) Other U/W expense incurred -20,000 (5.) Net U/W income -7,000 = (1) (2) (3) (4) (6.) Net investment income earned 15,000 (7.) Net realized capital gain 2,000 (8.) Net investment income 17,000 = (6) + (7) (9.) Net income before tax and PH dividend 10,000 = (8) + (5) (10.) PH dividends 5,000 (11.) Net income before FIT 5,000 = (9) + (10) (12.) FIT 250 (13.) Statutory net income after FIT 4,750 = (11) - (12)

57 QUESTION # 65 [All dollars in thousands} IGR =.08 Mean surplus allocated to GL = 500 Note: Assume answers are being calc for the 2003 IEE Mean agents bal GL = 55 Mean UPR GL = 125 Mean loss + LAE Res GL = 1,750 Expenses = comm. + taxes + other acq + ½ general for current year = = 140 expense = expenses curr. year = 140 =.2 ratio WP curr year 700 (A.) Inv gain for GL attrib to ins Trans = IGR x (Mean Loss+LAE Res GL +Mean UPR GL *(1-exp ratio GL)-Mean agt bal GL) =.08 X ( x (1-.2) 55) =.08 x (1795) = Inv Gain for GL in total = IGR x (Mean Loss+LAE Res GL +Mean UPR GL -Mean agt bal GL +surplus allocated to GL) =.08 x ( ) =.08 x (2320) = (B.) Inv Gain for GL attrib to Surplus = = 42.0

58 QUESTION # 66 (A.) Two Year Reserve Development ( ) + ( ) + ( ) + ( ) + ( ) + ( ) + ( ) + ( ) + ( ) = 89 (B.) Company Avg Development = Sum of 2003 Sum of Diagonal = 6909 = Company factor = 1.05 = Company adverse development =.21 x.9859 =.207 RBC Factor = [{ }+ 1 ] x.942 = Risk change % = QUESTION # 67 The square root rule will overstate the required capital for a given EPD (expected policyholder deficit) if the risk elements have a normal or lognormal distribution. The correlation is very weak & the main correlation between reserving risk and reinsurance collectibles is taken care of by moving ½ of the credit risk charge from R3 to R4.

59 QUESTION # 68 UEPR = 1M ELR = 800,000 PMC = 100,000 Adj. Exp = 250,000 DPAC = 50,000 Premium Deficiency = [(UEPR + Inv Inc - (ELR + PMC + Adj Exp + DPAC )] = [ ( )] = - [ ] = Since DPAC = IF we eliminate this DPAC amount from the Premium Deficiency we get Premium Deficiency Reserves of QUESTION # = The bonds held to maturity are carried at amortized value, the change in MV (market value) has no effect. The bonds available for sale are carried at MV, so they have created an unrealized cg (capital gain) of $2,100,000 2,000,000 = $100,000 The common stocks are carried at MV, so their unrealized CG is $330, ,000 = $30,000 Total unrealized CG = $100, ,000 = $130,000 Deferred tax on this is (0.35) ($130,000) = $45,500 Unrealized CG net of deferred taxes = $130,000 45,500 = $84,500

60 QUESTION # 70 This statement means that because companies come in all sizes and write any number of lines of coverage, the absolute value of an item will have a greater effect on a small company, with small surplus say, than on a large company with surplus in multiples of the small company. A reduction in surplus or a provision for reinsurance will have greater impact on a small insurer than that same amount would be a much larger insurer, for the small insurer it s material while for the larger it is not. QUESTION # 71 Invest in a higher proportion of taxable bonds than in the prior year. Underwriting losses will reduce regular taxable income + alternative minimum taxable income. Thus, fewer tax preference items are necessary to achieve the required relationship between RTI + AMTI such that the regular tax equals the alternative minimum tax + after tax net income is maximized.