Practice Education Course Finance and Investments Exam June 2014 TABLE OF CONTENTS

Practice Education Course Finance and Investments Exam June 2014 TABLE OF CONTENTS THIS EXAM CONSISTS OF SEVEN (7) WRITTEN ANSWER QUESTIONS WORTH 56 POINTS AND SEVEN (7) MULTIPLE CHOICE QUESTIONS WORTH 1 POINT FOR A TOTAL OF 63 POINTS. WRITTEN-ANSWER QUESTIONS Question 1 (13 points)... 2 Question 2 (5 points)... 3 Question 3 (8 points)... 4 Question 4 (5 points)... 5 Question 5 (7 points)... 6 Question 6 (12 points)... 7 Question 7 (6 points)... 8 MULTIPLE CHOICE QUESTIONS Question 1 (1 point)... 9 Question 2 (1 point)... 10 Question 3 (1 point)... 11 Question 4 (1 point)... 12 Question 5 (1 point)... 13 Question 6 (1 point)... 14 Question 7 (1 point)... 15 1

Question 1 (13 points) You need to peer review your company s economic scenario generator to be used for the valuation of your company s segregated fund guarantees for 2013. You are given a limited amount of documentation because the Modeling Unit that built the model is still working on the documentation report. They ensured that the model meets all the requirements for the valuation of the segregated funds for year-end 2013. They only gave you the results of their RSLN2 model simulations for the equity returns indices and the interest rates so you can start your review. The accumulation factors are summarized as follows: Equity Returns TSX Nasdaq Shanghai Composite Horizon: 1-year 5-year 10-year 1-year 5-year 10-year 1-year 5-year 10-year Percentiles 2.5 0.70 0.65 0.79 0.74 0.67 0.75 0.51 0.29 0.22 5.0 0.80 0.78 0.94 0.80 0.78 0.92 0.61 0.39 0.33 10 0.88 0.93 1.15 0.88 0.93 1.17 0.72 0.54 0.50 50 1.10 1.60 2.50 1.10 1.60 2.50 1.10 1.45 2.00 90 1.35 2.60 5.10 1.35 2.55 4.95 1.50 3.30 6.80 95 1.40 2.95 6.10 1.40 2.90 5.90 1.70 4.20 9.55 97.5 1.45 3.25 7.10 1.50 3.20 6.90 1.90 5.20 12.80 Interest Rates for Canada (obtained from 20,000 simulations) Horizon: 2-year 10-year 60-year 4% 6.25% 9% 4% 6.25% 9% 6.25% Percentiles 2.5 2.9% 4.3% 6.1% 2.5% 3.1% 3.9% 2.6% 5.0 3.1% 4.6% 6.5% 2.7% 3.4% 4.3% 2.9% 10 3.3% 4.9% 6.9% 2.9% 3.8% 4.8% 3.3% 90 5.2% 7.8% 10.8% 6.7% 9.2% 12.4% 10.1% 95 5.1% 8.2% 11.4% 7.5% 10.3% 14.2% 12.1% 97.5 5.5% 8.7% 12.0% 8.4% 11.6% 15.9% 14.5% Median 5.4% 6.2% 8.7% 4.5% 5.9% 7.6% 5.6% Mean 6.2% 6.3% 8.8% 4.7% 6.3% 8.2% 6.5% a) (8 points) Perform the review of the equity returns accumulation factors. Please document your work. b) (1 point) Summarize your response to the Modeling Unit regarding the equity returns model. c) (3 points) Perform the review of the accumulation factors for the interest rate model. Please document your work. d) (1 point) Summarize your comments, findings and recommendations to the Modeling Unit regarding the interest rates model. 2

Question 2 (5 points) You are the chief actuary of a Non-Canadian resident life insurance company whose resident country has a tax treaty with Canada. The company would like to begin selling non-participating 10-year term insurance business to Canadian residents backed by Canadian public bonds. a) (3 points) You have been asked to research the Canadian tax environment and draft a memo outlining the key tax considerations the company would need to consider when selling life insurance business in Canada. b) (2 points) Discuss the tax advantages of entering into a reinsurance agreement for this block of business. 3

Question 3 (8 points) Global Company is considering entering the segregated fund guarantee market. The regulator offers two capital standards (1) Capital Factors; and (2) Internal Model using a CTE risk metric. Most companies use the internal model (IM) approach. One month prior to launch, the regulator announces new stringent calibration requirements for the internal models. This means, for some types of products, the capital factor model will require less capital than the IM. Under the new IM calibration, the return on capital (ROC) is only at 5% which is well below the acceptable level of 12% for Global Company. The CFO has asked you, as the AA, to only use the capital factors approach for your new product, because the CFO wants the product to show an attractive ROC. a) (2 points) Explain the two different capital methods. b) (2 points) Explain why there might be differences especially why most companies are using the IM approach. c) (2 points) Assess the request from the CFO. d) (2 points) Recommendation on whether to support the product launch. 4

Question 4 (5 points) You begin the year 2013 as the Appointed Actuary of Plenty Life Insurance (PLI), a Canadian life insurance company. You keep a log of the year s events. February Annual return submitted (early!) 25 th April 10 th Initial investigation of PLI s main new segregated fund product Guarantees Plus (GP) indicates possible large risk exposure. April 15 th May 1 st June 30 th July 15 th August 1 st Appointed actuary s report filed. Annual meeting for PLI orally went over the valuation of policy liabilities at an appropriate level for the audience of shareholders and participating policyholders. Started work on quarterly reporting will base Dynamic Capital Adequacy Testing on this quarter s results. Just before going on vacation, I dropped by the CEO s office and mentioned the problems I perceived with GP. Came back to find GP had been launched with a wave of publicity immediately e-mailed a complaint to the CEO. September Presented DCAT to the board did not include any material related to GP as it 1 st was not released prior to second quarter. October 1 st Sent the DCAT report off to OSFI pleased that I got it in prior to the end of the year this time. As there was still no action by PLI in regard to GP I used the opportunity to notify OSFI about the problems with GP. November I opined to the board that too much participating policyholder surplus was being 1 st transferred to the shareholder s account under the Dividend Policy. November I was shocked to receive a phone call from an actuary in a consulting firm who 2 nd said he had been engaged by PLI as the new Appointed Actuary. Later I realized I was supposed to tell him the reason for my dismissal. I was going to e-mail him that it was probably my criticism of the Dividend Policy but I could not find him on the CIA listing. Analyze the appropriateness of the listed events. 5

Question 5 (7 points) Company ABC wants to enter the payout annuity market. It started to price a new payout annuity product. One goal is to offer a competitive product. It would provide a lifetime income to the contract holder which would have to choose between three monthly income options, i.e., receive $500, $2,000, or $5,000. The following is the assumed sales distribution of business: Monthly Income Distribution (Count) Distribution (Deposit) $500 20% 3% $2,000 30% 19% $5,000 50% 78% Gender Distribution (Count) Distribution (Deposit) Male 50% 60% Female 50% 40% Tax Type Distribution (Count) Distribution (Deposit) RRSP 55% 60% RPP 5% 8% Non- Registered 40% 32% Company ABC does not have internal experience and the previous pricing actuary has collected Canadian population data to set the mortality assumption. He read a few articles on annuitant s mortality and has determined the mortality assumption to be 94.7% of the 1983 IAM Basic Table and has priced with this assumption. 1) (3 points) You are the new pricing actuary. You will perform sensitivity tests on the assumption to determine the range of profitability. Explain what risks to the mortality assumption your sensitivity tests should be focusing on and describe the method you would use for testing them. 2) (2 points) As part of the pricing approval process, you must review the mortality assumption. Assess the appropriateness of the existing assumption. 3) (2 points) As the new pricing actuary, you are asked to develop pricing guidelines. In this process, you have to recommend pricing metrics. Draft a brief memo explaining your recommendation in terms of pricing metrics that would be appropriate for payout annuities. 6

Question 6 (12 points) As an alternative to developing a new payout annuity product, Company ABC is considering buying a payout annuity block of business from a competitor. This option would allow quick entry in the market and result in a payout annuity product that is already competitive. Company ABC is a federally regulated, publicly traded Canadian life insurance company. The following are the key financial capital information for ABC, in CAD millions (assume items not listed have zero impact on ABC): Common shareholder s equity = 500 Goodwill = 50 Senior debt = 300 Subordinated debt = 200 Negative reserves = 70 C1 required capital = 150 Mortality risk required capital = 25 Lapse risk = 100 C3 required capital = 100 ABC s internal capital targets = 190% MCCSR Ratio, 115% Tier 1 Ratio The block of business Company ABC is considering for acquisition would have the following impacts to its MCCSR: o Tier 1 capital = +50 o Tier 2 capital = +50 o Required capital = +75 a) (4 points) Explain the differences between internal capital targets and the supervisory targets. b) (3 points) Calculate the MCCSR ratio and the Tier 1 ratio for ABC at the current date. c) (2 points) Determine if ABC can support making the potential acquisition from a capital standpoint. Justify your response. d) (3 points) Describe two potential actions ABC can take to improve its capital position. Explain the advantages and disadvantages for each action. 7

Question 7 (6 points) After long negotiations, Company ABC finally acquired the payout annuity block of business from Company XYZ. Two years after Company ABC acquired the payout annuity block of business from Company XYZ, Company ABC publicly discloses its Sources of Earnings (SOE) at an industry-consistent level by following the guidance set forth by OSFI and the Canadian Institute of Actuaries. 1) (1 point) Company ABC s policy administration system is more sophisticated and efficient than Company XYZ s, resulting in a permanent annual per policy expense reduction after the acquisition and transfer of the business to Company ABC. What component line of the SOE analysis would this experience be allocated to, and why? 2) In the two years following the payout annuity purchase, the block has had the following experience: End of: Year 1 Year 2 Expected best estimate reserve released: 1,500 1,510 Actual best estimate reserve released: 1,475 1,480 Expected annuity payments: 5,000 4,950 Actual annuity payments: 5,050 5,010 a) (1 point) Indicate which line of the SOE this experience would be reported in and its earnings impact in each year? b) (1 point) What is the likely driver of this experience? c) (1 point) What action can Company ABC take, and where would the impact of this action be reported in a subsequent SOE analysis? 3) (1 point) Describe two other common SOE component categories that Company ABC would include in their disclosure that have not yet been discussed in this question. 4) (1 point) Company ABC s CEO wants to use the SOE as a management tool because it can be presented by product lines, divisions and companies. Explain the shortcomings of using the SOE as a management tool. 8

Multiple Choice Questions Question 1 (1 point) Company A was incorporated in Canada on July 1, 1950, maintains its head office in Toronto, Ontario and has continuously sold insurance policies in Canada since its date of incorporation. In 2013, the company opened a foreign branch office which generated $10 Million of income on business generated in that country. How much tax did Company A have to pay in Canada on the $10M of foreign income? A) $1.5 Million B) $0.75 Million C) $0 D) $2.6 Million E) None of the above 9

Question 2 (1 point) Which of the following statements are true in regard to IFRS for financial instruments? I. Companies may not designate assets backing liabilities as Available for Sale at outset. II. III. Companies must classify assets similarly under all accounting regimes (e.g., IFRS and USGAAP). Changes in fair value of assets designated as Held-to-maturity will be recorded as Other Comprehensive Income. A) I only B) II only C) I and II only D) II and III only E) None of the above 10

Question 3 (1 point) In regard to the Canadian Asset Liability Method (CALM) which of the following statements are accurate? I. Approximations to CALM are acceptable if they comply with the spirit of the standards. II. III. An approximation using a level equivalent interest rate may not be appropriate if there are future tax and statement reserve differences. It may be necessary to use approximations in performing dynamic capital adequacy tests due to the number and length of scenarios. A) All B) None C) All but I D) All but II E) I only 11

Question 4 (1 point) You need to re-price a product that currently is known for shifting benefit pattern in favor of those that stay over those that lapse. Which of the following statement(s) are you not expecting to see in the lapse rate analysis? I. Smokers to have higher lapse rates than non-smokers. II. Non-monthly premium policies to have lower lapse rates than monthly premium policies. III. Lapse rates decrease as face amount increases. IV. Joint-last-to-die policies to have higher lapse rates than joint-first-to-die policies. A) Only II B) II and IV C) III and IV D) Only IV E) I and II 12

Question 5 (1 point) Company X is in severe financial difficulty. Which of the following statements are true? I. If known, Company X s financial condition will cause an automatic Disciplinary Committee action. II. III. The Canadian Institute s policy in regard to fairness to participating policyholders precludes a change to the dividend policy. Cessation of compensation from Company X is not grounds for refusing to cooperate with other members in regards to Company X issues. A) All B) I only C) All but II D) All but III E) Answer not given by A, B, C or D 13

Question 6 (1 point) Which of the following statements are true in regards to the use of hedge contracts in the context of capital determination for segregated funds? I. The amount of recognition is determined at the time of purchase. II. III. The amount of recognition depends on the additional risk it generates. The hedge contracts can be combined with other financial instruments (e.g., equities, futures contracts, options contracts) which are different from the segregated fund guarantee risk exposure, and a capital requirement for the resulting combination can be determined. A) All B) I only C) All but I D) All but III E) Answer not given by A, B, C or D 14

Question 7 (1 point) Random Life offers a segregated fund with 100% Guaranteed Minimum Death Benefit and 100% Guaranteed Minimum Maturity Benefit on S&P/TSX 60 index. Their hedge strategy is to roll 1-month futures positions. 1-month S&P/TSX 60 index Futures are available at the Montreal Exchange. Consider the risk and costs in this hedging program, choose the risks that represent the three largest risk exposures from the list below: I. Basis Risk II. Liquidity Risk III. Transaction Risk IV. Counterparty Risk V. Volatility Risk VI. Interest Rate Risk A. I, II and VI B. I, III, and IV C. I, III and V D. II, IV and VI E. II, V and VI 15