ILA LPM Model Solutions

Fall 2020

1. Learning Objectives:
1. The candidate will understand the designs and risks of the common life and
annuity products and features, as well as the methods and metrics used to design
and price these products.

2. The candidate will understand the theory of "Value Creation" for life and annuity
products and how to evaluate the patterns of earnings emergence under various
regulatory regimes.

Learning Outcomes:
(1b) Describe and evaluate methods and metrics used to design and price these
products, and assess their profitability.

(1q) Describe and evaluate the types of assumptions commonly used in actuarial
pricing and product development.

(2d) Describe and evaluate how Source of Earnings analyses can enhance
understanding of the drivers of earnings, and apply the methodology.

Sources:
LPM-165-19: Life Products and Features, ILA Committee, 2019

Post Level Term Experience Results, 2014, pp. 21-44

ASOP 54: Pricing of Life and Annuity Products, Jun 2018

LPM-154-19: Introduction to Source of Earnings Analysis, 2015, Exclude Appendix

Commentary on Question:
This question compares Term Insurance and UL product characteristics and the selection
of appropriate assumptions. A secondary focus is on profitability measurement
comparisons & a source of earnings analysis. Candidates did well on parts (a) and (c)
and struggled more on parts (b) and (d). See separate comments below.

Solution:
(a) You are given the following information about Term Co’s 5 and 10-year level
term life insurance products:

ILA LPM Fall 2020 Solutions Page 1

1. Continued

• They are renewable at a higher premium amount beyond the initial level term
period pattern
• The issue age range is 18-65
• There is no maximum face amount
• Premium rates per 1,000 do not vary by face amount
• The mortality pricing assumption is based on Term Co experience and varies
by gender and attained age

Critique the mortality pricing assumption.

Commentary on Question:
This question tests candidates’ understanding of types of assumptions commonly
used in actuarial pricing and product development. Candidates were asked to
evaluate mortality assumption for a Term product. Many candidates did well on
this question. Full credit was awarded to candidates who made two well
explained points below.

• Attained age mortality tables make it difficult to be competitively priced

across a range of issue ages
• Currently there is no face bands, mortality is generally better for higher bands
than the rest.
• Renewal mortality in the post-level period is influenced by unhealthy lives
retaining coverage (anti-selection)
• Post-level term mortality is largely dependent on the magnitude of the shock
lapse
• Consider separating smoker/non-smoker or other underwriting criteria

(b) You are given Term Co’s 10-year term GAAP results for the prior quarter:

Aggregate Reserve Rollforward

Beginning of Period Reserves 675,000
Net Premium 370,000
Reserve Released for Maintenance Expenses (125,000)
Interest Added to Reserves X
Reserve Released for Death Benefits (220,000)
Reserve Released for Surrenders (18,000)
End of Period Reserves 695,500

ILA LPM Fall 2020 Solutions Page 2

1. Continued

Actual Experience
Net Premium 390,000
Investment Income 9,500
Death Benefits Paid 245,000
Surrender Benefits Paid 0
Maintenance Expenses Paid 128,000

(i) (0.5 point) Calculate X in the Aggregate Reserve Rollforward. Show all
work, including writing out relevant formulas used in any calculations.

(ii) (2.5 points) Create a Source of Earnings analysis for the actual results.

(iii) (1 point) Determine the expected total variance between actual results and
projected valuation results. Show all work, including writing out relevant
formulas used in any calculations.

Commentary on Question:

This question tests candidate's understanding of Source of Earnings analyses.

Candidates were asked to apply the methodology to perform a numerical
calculation for a given scenario with different drivers of earnings. Most of
candidates did relatively well in part (i) and (ii), but poorly on part (iii). Many
candidates don’t understand what’s the difference between the net profit on
valuation basis vs. actual result basis.

(i) Interest Added to Reserves

= End of Period Reserves - (Beginning of Period Reserves + Net Premium +
Reserve Released for Maintenance Expenses + Reserve Released for Death
Benefits + Reserve Released for Surrenders)
= 695,500 – (675,000+370,000-125,000-220,000-18,000) = 13,500

ILA LPM Fall 2020 Solutions Page 3

1. Continued

(ii)
Source of Earnings Analysis Actual Results
In Force Profit Margin
Actual Gross Premium 390,000
GAAP Reserve Premium (370,000)
Net 20,000
Experience - Investment Gains
Investment Income 9,500
GAAP Reserve Interest (13,500)
Net (4,000)
Experience - Mortality
Actual Death Benefits (245,000)
GAAP Reserve Released for Death Benefits 220,000
Net (25,000)
Experience - Lapse
Actual Surrender Benefits -
GAAP Reserve Released for Surrender Benefits 18,000
Net 18,000
Experience - Expenses
Actual Expenses (128,000)
GAAP Reserve Released for Expenses 125,000
Net (3,000)
TOTAL 6,000

(iii) On the Valuation basis, it will just be the inforce profit margin (or difference
in actual gross premium and GAAP reserve premium that results in a profit
margin), which is 20,000
The net profit from actual results is 6,000 from part (ii)
Therefore, the expected total variance between actual results and projected
valuation results is 6,000 – 20,000 = 14,000

(c) Describe considerations that should be incorporated into the following term
assumptions before they are used to price the UL product:

(i) Mortality

(ii) Lapse

(iii) Interest

ILA LPM Fall 2020 Solutions Page 4

1. Continued

Commentary on Question:
This question continues to test candidates’ understanding of types of assumptions
commonly used in actuarial pricing and product development. Candidates were
expected to focus the arguments on difference for each assumption between Term
and UL products based on different characteristics of the products. Candidates
generally did well on this question.

(i) Mortality
Mortality can generally be expected to be similar across term and UL although
adjustments would be needed for:
• Mortality is influenced by shock lapses on term which do not impact UL
• Term mortality is based on higher face amounts leading to better mortality
• Term has low long term persistency leading to improved mortality rates
• Implementation of the AUW program can result in 5-10% increase in
expected mortality for those that qualify
• For those who do not qualify and need to go through full underwriting, the
mortality should be similar

(ii) Lapse
• Term will have selective lapsation after level period, which does not apply
to UL
• UL lapses need to be supplemented with an assumption for partial
withdrawals
• UL lapses tied to market performance, guarantees, the level of crediting
rates, as well as overall interest environment etc.

(iii) Interest
• Term reserve interest rates will not be directly applicable to UL
• UL interest rate assumptions will need to be more complicated. In
addition to a rate of return on assets, UL needs assumption for the rate
credited to the account which can either be guaranteed, or based on
portfolio of assets backing the fund

(d) List considerations when selecting a profitability metric.

Commentary on Question:
This question asks candidates to make general comments on the considerations
when selecting a profitability metric. Some candidates misunderstood the
question to propose different profitability metrics for Term and UL products.
Partial credit was given when candidates provided valid explanation and
consideration for selected profitability metric.

ILA LPM Fall 2020 Solutions Page 5

1. Continued

• The expected pattern of profits over time (for example, the pattern of gains
and losses, however measured);
• the significance of the product’s underlying risks (for example, the size
and pattern of risk capital); and
• any other considerations that the actuary determines are relevant (for
example, limitations of the profitability metric for the product being
priced; multiple metrics may be adopted if deemed appropriate and
relevant)

ILA LPM Fall 2020 Solutions Page 6

2. Learning Objectives:
1. The candidate will understand the designs and risks of the common life and
annuity products and features, as well as the methods and metrics used to design
and price these products.

Learning Outcomes:
(1a) Describe the designs of the common life and annuity products and evaluate their
associated features and inherent risks.

(1p) Describe and apply methods for pricing term conversions.

(1q) Describe and evaluate the types of assumptions commonly used in actuarial
pricing and product development.

Sources:
Level Term Lapse Rates – Lessons Learned Here and in Canada, Product Matters, Oct
2011

Term Conversions: Pricing and Reserving, Product Matters, Mar 2017

Term Conversions - A Reinsurers Perspective, Product Matters, Jun 2012

Report on the Conversion Experience Study for the Level Premium Term Plans, 2015

LPM-165-19: Life Products and Features, ILA Committee, 2019

Commentary on Question:
Commentary listed underneath question component.

Solution:
(a) Evaluate ABC’s plan to set term lapse assumptions for 2020 new business based
on ABC’s historical lapse experience for the level term and post-level term
periods.

Commentary on Question:
Most candidates were able to identify ABC should not just use company’s
historical lapse experience. At the end of level term period there are shock lapses
due to steep post level term premium increases. However, most candidates missed
the fact that competition and preferred underwriting classes drove premium rates
down which led to higher lapse rates historically.

Partial credit was awarded if a candidate mentioned lapse assumptions should

reflect conversion rates or lapse rate may decrease once conversion is offered.

ILA LPM Fall 2020 Solutions Page 7

2. Continued

ABC should not just use historical lapse experience for new business pricing
assumptions as term products have changed significantly in the last decades and
may not be relevant appropriate for new business.

• Level term period:

o Fierce competition and introduction of preferred classes drove
premium rates down, which led to high replacement activity and
lapse rates in earlier decades.
o New generation level term lapse rates (post early to mid-2000’s)
tend to be lower than in prior decades.

• End of level term period shock lapse:

o Rate competitions led more companies to lower premiums in level
period and try to recoup with steeper post-level term rates, which
resulted in higher shock lapses for new generation products.

• Post-level term period:

o Higher shock lapses and increased post level term premiums would
result in a different residual cohort exhibiting different lapse
behaviors.

(b) ABC will introduce a conversion option on its term products, allowing
policyholders to convert to one of ABC’s permanent products before the end of
the initial level term period.

(i) Explain how a conversion option benefits the policyholder.

(ii) State two reasons why companies would offer conversion options on their
term products.

(iii) (2 points) Explain the advantages and disadvantages of building

conversion costs into ABC’s term products as opposed to their permanent
products.

Commentary on Question:
For part (i), most candidates discussed one of the benefits is unhealthy
individuals can covert to permanent policy without being re-underwritten. Only a
few candidates mentioned the other benefit of conversion for healthy lives.

Candidates did well on part (ii). Credit was awarded if a candidate mentioned
permanent product is (generally) more profitable than term.

Most candidates did well on part (iii), but only few candidates discussed the
disadvantage from the profitability tracking / experience study perspective.

ILA LPM Fall 2020 Solutions Page 8

2. Continued

(i) Policyholders gain access to permanent coverage that does not reflect high
concentration of less healthy individuals who typically persists post-level
term and contribute to rapidly increasing premiums after the initial term.

Moreover, conversion privilege is an option to policyholders. If

policyholders are healthy enough to get re-underwritten, they benefit from
qualifying for a new plan and if they are unhealthy, they can exercise the
conversion privilege.

(ii) 1. Help sales of term products:

Conversion option makes the product more attractive with future
benefit to the policy holder and makes the product more
competitive if all your competitors are offering a conversion
privilege.

2. Help increase permanent business:

It helps retain healthy lives that might otherwise lapse if they
purchase permanent insurance with another company and also rolls
them into a potentially more profitable product.

(iii) Advantages:

• Covering conversion costs in the term product is fairer, since it is

spread across those who have the right, though not the obligation,
to convert to a permanent product.
• Conversion costs then depend on the volume of business with the
conversion option. Pricing for conversion costs in permanent
products is more difficult because the actuary must accurately
estimate not just the term conversion rate, but the volume of
permanent business across which the conversion costs are to be
spread.

Disadvantages:

• Term is a very price sensitive product. Allocating conversion costs

may put the carrier at a disadvantage compared to those who
embed conversions costs in permanent products or do not assume
any conversion costs.

ILA LPM Fall 2020 Solutions Page 9

2. Continued

• Depending on the carrier’s administrative capabilities, there is

misalignment between the line of business where conversion costs
are paid for (term block) and where the costs will occur
(permanent block). This may overstate term’s profitability and
understate permanent product’s profitability when reporting
earnings. It may also result in a misalignment of excess mortality
when performing experience studies since converted policy claims
will increase mortality for the for the permanent product.

(c) ABC’s Pricing Actuary has proposed the following assumptions to price the
conversion option of its 10-year term product. ABC uses the same mortality rates
for term and permanent life business.

Conversion Rate: 6% at the end of each year in years 1 to 10

Post - Conversion Mortality: 120% of ABC’s current point-in-scale
mortality rates for all conversions in
durations 1-10
Lapse rate: 0% in all years
Interest rate: 0% in all years

Additionally, you are given the following for a policy issued at age 50:

Converted face amount = initial face amount = 500,000

q[50] 0.0011
q[50]+1 0.0014
∑∞
𝑡𝑡=0 tpʹ[50]+1 * q[50]+1+t = 0.81
∑∞
𝑡𝑡=0 tpʹ[50]+2 * q[50]+2+t = 0.79
tp[x]+s,
q[x]+s denote survivorship and mortality for ABC’s base mortality
assumptions (prior to the conversion offering)
tpʹ[x]+s denotes survivorship of a converted policy

(i) (3 points) Calculate the expected conversion cost of this policy for
conversions in the first 2 durations using ABC’s proposed conversion
assumptions. Show all work, including writing out relevant formulas used
in any calculations.

(ii) (2 points) Critique the proposed conversion rate and post-conversion

mortality assumptions, based on the findings of the SOA Report on the
Conversion Experience Study for Level Premium Term Plans.

ILA LPM Fall 2020 Solutions Page 10

2. Continued

Commentary on Question:
Candidates generally struggled with part (i) as many did not appropriately set up
the formula for the extra mortality cost K(50,r) nor did many capture conversion as
a decrement in calculation A(50,2)

For part (ii), most candidates stated that conversion mortality should be revised
and the conversion rate should be higher in late durations, but most candidates
were not able to identify the 6% conversion rate is too high according to SOA
study

(i) where:

𝐾𝐾(50,𝑟𝑟) = 𝑃𝑃𝑃𝑃 𝑜𝑜𝑜𝑜 𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒 𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚 𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐 𝑓𝑓𝑓𝑓𝑓𝑓 𝑎𝑎𝑎𝑎𝑎𝑎 (50 + 𝑟𝑟)

𝑞𝑞 ′ [50]+𝑡𝑡 = 𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑙𝑙𝑙𝑙𝑙𝑙𝑙𝑙 𝑜𝑜𝑜𝑜 𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐 𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝 = 1.2 ∗ 𝑞𝑞[50]+𝑡𝑡

AR = Amount at risk = 500,000

∞

𝐾𝐾(50,𝑟𝑟) = � � 𝑡𝑡𝑝𝑝′[50]+𝑟𝑟 ∗ �𝑞𝑞 ′ [50]+𝑟𝑟+𝑡𝑡 − 𝑞𝑞[50]+𝑟𝑟+𝑡𝑡 � ∗ 𝐴𝐴𝐴𝐴 ∗ 𝑣𝑣�

𝑡𝑡=0
∞

𝐾𝐾(50,1) = � � 𝑡𝑡𝑝𝑝′[50]+1 ∗ �1.2 ∗ 𝑞𝑞 [50]+1+𝑡𝑡 − 𝑞𝑞[50]+1+𝑡𝑡 � ∗ 𝐴𝐴𝐴𝐴 ∗ 𝑣𝑣�

𝑡𝑡=0
∞

𝐾𝐾(50,1) = �� 𝑡𝑡𝑝𝑝′[50]+1 ∗ �0.2 ∗ 𝑞𝑞[50]+1+𝑡𝑡 � ∗ 𝐴𝐴𝐴𝐴 ∗ 𝑣𝑣�

𝑡𝑡=0
∞

𝐾𝐾(50,1) = ��0.2 ∗ 𝑡𝑡𝑝𝑝′[50]+1 ∗ 𝑞𝑞[50]+1+𝑡𝑡 ∗ 𝐴𝐴𝐴𝐴 ∗ 𝑣𝑣�

𝑡𝑡=0

𝐾𝐾(50,1) = (0.2 ∗ 0.81 ∗ 500,000 ∗ 1) = 81,000

𝐾𝐾(50,2) = (0.2 ∗ 0.79 ∗ 500,000 ∗ 1) = 79,000

𝐴𝐴(50,𝑟𝑟) = 𝑃𝑃𝑃𝑃 𝑎𝑎𝑎𝑎 𝑎𝑎𝑎𝑎𝑎𝑎 50 𝑜𝑜𝑜𝑜 𝑡𝑡ℎ𝑒𝑒 𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒 𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚 𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐 𝑑𝑑𝑑𝑑𝑑𝑑 𝑡𝑡𝑡𝑡
𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐 𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒 𝑎𝑎𝑎𝑎 𝑡𝑡ℎ𝑒𝑒 𝑒𝑒𝑒𝑒𝑒𝑒 𝑜𝑜𝑜𝑜 𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝 𝑦𝑦𝑦𝑦𝑦𝑦𝑦𝑦 𝑟𝑟

𝐴𝐴(50,1) = 1𝑝𝑝[50] ∗ 𝑒𝑒 ∗ 𝐾𝐾(50,1) ∗ 𝑣𝑣

1𝑝𝑝[50] = 1 − 𝑞𝑞[50] = 0.9989 𝑎𝑎𝑎𝑎𝑎𝑎 𝑒𝑒 = 6%

𝐴𝐴(50,1) = 0.9989 ∗ 6% ∗ 81,000 ∗ 1 = 4,855

ILA LPM Fall 2020 Solutions Page 11

2. Continued

𝐴𝐴(50,2) = 2𝑝𝑝[50] ∗ 𝑒𝑒 ∗ 𝐾𝐾(50,2) ∗ 1

2𝑝𝑝[50] = 1𝑝𝑝[50] ∗ (1 − 𝑒𝑒) ∗ �1 − 𝑞𝑞[50]+1 � = 0.9377

𝐴𝐴(50,2) = 0.9377 ∗ 6% ∗ 79,000 ∗ 1 = 4,444

Conversion cost in the first 2 durations = 4,855 + 4,444 = 9,299

(ii) 1. Conversion rate:

• 6% is high for conversion rate. SOA study showed ~1% for

duration 1-9. ABC should lower the conversion rate in duration 1-
9.

• Conversion rate should vary by duration. Usually highest in the

last year of conversion period due to premiums are generally less
expensive than permanent product. ABC should revise the
conversion rate assumption to have a spike in duration 10.

2. Post conversion mortality assumption:

• According to SOA study, mortality deterioration multiplier should

vary by duration at conversion due to anti-selection at the end of
the level term period. ABC should use a higher mortality multiple
for late converters. Also based on the study, the mortality rate
should slowly reduce following the spike at conversion.

ILA LPM Fall 2020 Solutions Page 12

3. Learning Objectives:
5. The candidate will understand the role of the Investment Actuary and the
Portfolio Management Process in the Life Insurance company context, as well as
the common forms of Fixed income securities and their uses, and the methods and
processes used for evaluating portfolio performance and asset allocation.

Learning Outcomes:
(5f) Describe and apply methods and processes for evaluating portfolio performance,
including performance attribution, sources of earnings analysis on investment
income, benchmarks, metrics, and risk adjusted performance appraisals (including
total return vs reported earnings).

(5g) Describe the principles of Liquidity Risk Management in an insurance company

portfolio management context.

(5i) Describe the attributes of US Treasuries, Agency Debt Securities, Municipal

bonds, Corporate bonds, Private Money Market securities, Floating Rate
Agreements, Agency Mortgage Backed securities, Agency Collateralized
Mortgage securities, Interest Rate Swaps and Swaptions, Credit Derivatives and
High Yield Bonds, and the markets they are traded in.

Sources:
Managing Investment Portfolios, Chapter 5: Asset Allocation

Handbook of Fixed Income Securities, Chapter 17: Floating-Rate Securities

Managing Investment Portfolios, Maginn, John L. and Tuttle, Donald L., 3rd Edition,
2007 - Ch. 3:

Commentary on Question:
Commentary listed underneath question component.

Solution:
a) Compare SAA and TAA.

Commentary on Question:
Most candidates answered this question correctly.

• SAA has a long term view while TAA has a short term view
• SAA is a passive investment strategy and TAA is an active strategy
• SAA reviewed less frequently (annually or when the investment objective
changes), it requires fewer management and adjustments. TAA revisited
more frequently (monthly or quarterly) and will change allocation based
on short term market expectations.

ILA LPM Fall 2020 Solutions Page 13

3. Continued

(b) You are given that DEF’s numerical risk aversion is 4, and the following for the
funds under consideration:

Fund A Fund B
Expected Return 10% 8%
Historical Return 11% 7%
Standard Deviation of Return 5% 3%

(i) Calculate the utility for each fund. Show all work, including writing out
relevant formulas used in any calculations.

(ii) Calculate Roy’s safety-first criterion for each fund, assuming the spending
rate is 5% and the inflation rate is 2%. Show all work, including writing
out relevant formulas used in any calculations.

(iii) Recommend which fund DEF should invest in. Justify your answer.

Commentary on Question:
Candidates were given partial credit if they demonstrated an understanding of
what the question was asking (i.e. partial credit was given to candidates who did
not get the correct final answer but included the formula and showed all work).

Some common mistakes included: (1) using historical return instead of expected
return and (2) using additive formula when calculating the required yield.

(i)
Utility = Expected Return – 0.005 * Risk Aversion * (Standard Deviation of
Return)^2
Utility (A) = 0.01 - 0.005 * 4 * (0.05 ^2) = 0.09995 (or 9.995%)
Utility (B) = 0.08 - 0.005 * 4 * (0.03 ^2) = 0.07998 (or 7.998% )

(ii)
Roy’s Safety First Ratio (SFR) = (Expected Return – Required Yield)/Standard
Deviation of Return

Required Yield = (1 + Spending Rate) * (1 + Inflation) – 1

= (1+5%)*(1+2%)-1 = 7.1%

SFR (A) = (0.1 – 0.071)/0.05 = 0.58

SFR (B) = (0.08 – 0.071)/0.03 = 0.3

(iii)
Recommend fund A because it has higher utility and higher safety-first ratio.

ILA LPM Fall 2020 Solutions Page 14

3. Continued

(c) Both funds include investments in floating rate securities (“floaters”) which back
the guaranteed crediting rate offered by the UL product. The floaters are based on
a three-month London Interbank Offer Rate (LIBOR) with a floor. Critique the
following statements:

A. The floater’s price is very sensitive to interest rates. The price fluctuation
is more sensitive than a fixed coupon bond. A factor that may change the
price of a floater is whether the floor is reached.

B. Investing in floaters with a floor is a good strategy if you think that the
LIBOR will increase above the guaranteed crediting rate.

C. This portfolio will not face any reinvestment risk because the average
duration of the floaters is longer than the duration of the UL guaranteed
crediting rate.

D. The duration of floaters will not be impacted by changes in interest rates

because floaters adjust their coupon rates based on LIBOR, unless they
are reaching the floor.

Commentary on Question:
To receive full credit, candidates had to (1) state whether the statement was
correct or incorrect, and (2) provide justification for each. Many candidates
struggled with part (c).D.

(c).A: Statement is incorrect.

• The price of a floater has little sensitivity to interest rates since the
floater’s coupon adjusts with interest rate movements
• Floater price is less sensitive to changes in the interest rates when
compared to fixed coupon bond
• The price of a floater may change is the cap or the floor is reached
• If the floor is reached, the floater behaves line a fixed rate bond

(c).B: Statement is incorrect.

• Investing in a floater with a floor is a good strategy if you think that the
reference rate will decrease when the floor is reached
• The floor provides protection, so if you think that the rate will increase
above the guaranteed crediting rate, the floor will not be triggered

(c).C: Statement is incorrect.

• The portfolio will face reinvestment risk because the coupons or principal
will need to be reinvested at the current rate if it’s less than the original
coupon or purchase rate.

ILA LPM Fall 2020 Solutions Page 15

3. Continued

• Even if the floater duration is longer than the duration of the UL

guaranteed crediting rate, the adverse movement in the rate will result in
lower yield on the reinvested coupons.
• A longer asset duration can have reinvestment risk

(c).D: Statement is incorrect.

• Floater’s sensitivity to each component of the coupon formula is estimated
using index duration and spread duration.
• Index duration measures the floater’s price sensitivity to changes in the
reference rates while holding the quoted margin constant.
• Spread duration measures the floater’s price sensitivity to a change in the
quoted margin or spread assuming the reference rate remains unchanged.
• If we assume that the index duration will have no impact, the spread
duration will have an impact with the market movement.

ILA LPM Fall 2020 Solutions Page 16

4. Learning Objectives:
1. The candidate will understand the designs and risks of the common life and
annuity products and features, as well as the methods and metrics used to design
and price these products.

Learning Outcomes:
(1a) Describe the designs of the common life and annuity products and evaluate their
associated features and inherent risks.

(1q) Describe and evaluate the types of assumptions commonly used in actuarial
pricing and product development.

(1r) Describe and evaluate the role of Behavioral Economics in understanding and
modeling policyholder behavior in the life and annuity context.

Sources:
LPM-166-19: Annuity Product and Features

Modeling of Policyholder Behavior for Life and Annuity Products, SOA

Commentary on Question:
Commentary listed underneath question component.

Solution:
(a) Describe two challenges insurers face in modeling policyholder behavior.

Commentary on Question:
For maximum points, candidates must give descriptions in addition to listing two
examples. Many candidates received partial credit because they described only
one challenge. Most candidates addressed data availability/credibility as a
challenge but struggled to provide other examples.

Solution:

(1) Data availability: rapid product development combined with the rise of new
product designs has resulted in a lack of credible experience data available to
insurers
(2) Model complexity: modeling policyholder behavior requires complex models
and sophisticated techniques which may not be available in insurers’ existing
software packages

(b) With regard to understanding and modeling policyholder behavior, you are given
the following current practices for XYZ insurance company:

ILA LPM Fall 2020 Solutions Page 17

4. Continued

Category XYZ Current Practices

• Reviewing company experience analysis
Data collection,
analysis, and • Maintaining an assumption repository for policyholder
assumption behavior including information from the administrative
setting system

• Assumptions are owned by each functional group (Pricing,

Modeling ALM, Valuation)

• Model steward validates changes and results at high level

Validation
• Based upon resource availability, periodic updates are
performed for experience data
Governance
process • Assumption changes are recommended and approved
informally within each functional group

Evaluate whether XYZ’s current practices are consistent with industry current
practices for each category.

Commentary on Question:
For maximum points, each of the current practices must be evaluated, including
providing examples of how the practice could be improved to become consistent
with industry practice. Many candidates did not receive maximum credit because
they either failed to suggest changes or did not address each bullet point. Of the
four categories, candidates had the most success addressing the governance
process.

Solution:
• Data analysis, collection, and assumption setting
o XYZ should also look at external data (e.g., industry).
o For the repository, should consider expanding beyond admin to include
data from underwriting or sales systems.
• Modeling
o Modeling packages/approaches should be reviewed across functions to
ensure there are no inconsistencies
• Validation
o Should have a model steward. However, should have a formal process for
both high level and detailed validation of changes and results.

ILA LPM Fall 2020 Solutions Page 18

4. Continued

• Governance process
o Periodic updates should not be based on resource availability. A formal
process should be put in place for updating experience data.
o Informal recommendation and approval are not consistent – Chief Actuary
or other appropriate individual(s) should provide formal signoff on
assumption changes.

(c) XYZ has completed product development for a new Indexed Annuity product and
has experience with a Variable Annuity with a Guaranteed Minimum Withdrawal
Benefit (GMWB) product.

Critique the following statements:

A. The cost of adding a GMWB rider is typically higher on an Indexed

Annuity than a Variable Annuity.

B. XYZ must hedge a GMWB on an Indexed Annuity using the same

approach currently used on the Variable Annuity GMWB.

C. XYZ can follow basic CARVM reserving, as covered in Actuarial

Guideline 33, for the Indexed Annuity.

D. Because XYZ does not have a clearly defined hedging strategy, it must use
the book value of relevant hedging instruments as the basis for its
reserving.

Commentary on Question:
To receive maximum points, candidates must provide analysis of each statement
beyond simply answering true/false. Most candidates received partial credit for
providing supporting detail for some statements but often were not able to
articulate the relevant differences between variable and indexed annuities.

Solution:
(A) False. Cost is usually higher on a Variable Annuity since Indexed Annuity
usually has a floor of zero
(B) Not necessarily true as some companies do not hedge the GMWB on a Fixed
Indexed Annuity
(C) True. XYZ does need to follow AG 33, but AG 35 also applies since the
method of crediting interest to the annuity is nontraditional
(D) False. With no clearly defined hedging strategy, XYZ must use fair market
value of hedging instruments.

ILA LPM Fall 2020 Solutions Page 19

4. Continued

(d) You are asked to perform a projection of liabilities for XYZ’s new Indexed
Annuity product and are given:

Indexed Annuity Current Data Current Structure

Assumption Source (Static or Dynamic)
Surrenders Company data Dynamic
Withdrawals Company data Static
GLB Utilization Company data Static
Annuitizations Company data Dynamic

Evaluate the appropriateness of the data source and structure for each of the above
assumptions.

Commentary on Question:
Partial credit was given if the candidate only indicated if the source or structure
were appropriate with no additional detail. For maximum points, candidates must
provide an evaluation. Most candidates failed to provide additional commentary
for data sources, such as credibility concerns or the use of external data.
Regarding structure, many candidates struggled to indicate the correct approach,
particularly for annuitizations.

Solution:

• Surrenders
o Company data is appropriate, but credibility should be reviewed
since there will be differences between the variable and indexed
annuity product features
o Dynamic structure appropriate since surrenders will be sensitive to
changes in market conditions
• Withdrawals
o Company data is appropriate, but credibility should be reviewed
since there will be differences between the variable and indexed
annuity product features
o Static structure is appropriate (withdrawals won’t vary much)
• GLB Utilization
o Company data is appropriate but should consider supplementing
with industry data
o Should use dynamic structure
• Annuitizations
o Company data is appropriate but should review due to differences
between the variable and indexed annuity product features
o Dynamic is inappropriate – should use static structure since it
won’t vary much.
ILA LPM Fall 2020 Solutions Page 20
5. Learning Objectives:
1. The candidate will understand the designs and risks of the common life and
annuity products and features, as well as the methods and metrics used to design
and price these products.

Learning Outcomes:
(1r) Describe and evaluate the role of Behavioral Economics in understanding and
modeling policyholder behavior in the life and annuity context.

Sources:
LPM-110-07: Policyholder Dividends, De Palo, 1997

Modeling of Policyholder Behavior for Life and Annuity Products, SOA, 2014, pp. 6, 9-
16 & 19-73

Commentary on Question:
In general, candidates didn’t do well, especially in part b). Most candidates were able to
critique some of the recommendations in part c) but unfortunately no one was able to
point out all inappropriateness with proposed changes.

Solution:
(a) List the Dividend Actuary’s key considerations in determining a reasonable
amount of annual contributions to surplus.

Commentary on Question:
Full points were awarded if candidate listed any 3 out of 4 bullets below. The
majority of candidates that were able to connect with correct source material
earned all points in this part. Many candidates confused the question with
“Contributory principle” or “dividend actuary’s responsibilities”. No point were
given in either case.

1. Allow the company to grow at target rate

2. Avoid increasing unit expense costs
3. Maintain total surplus over long periods at least at a minimum level related to
future risks
4. Should not be varied by growth of new business or changes in new business
strain

(b) Compare the considerations for the charge applied on dividends for mutual
companies versus the charge for profits paid to stockholders for stock companies.

ILA LPM Fall 2020 Solutions Page 21

5. Continued

Commentary on Question:
Candidates did poorly on this part. Almost all candidates attempted to explain
ownership difference of mutual companies and stock companies which was not
what the question asked. Some focused on comparing “amount” as which one
would have a higher charge while the question was asking about
“considerations”. Candidates did demonstrate a slightly better understanding of
mutual companies than stock companies.

Mutual companies and stock companies have different considerations for a charge
on dividend/profits:
• For mutual companies, the most important consideration is the ability to
support expected long-term growth
• For stock companies, a charge on profits must be determined in a fair
fashion due to limitations imposed by law
In addition, for mutual companies, the charge on dividends should be:
• Sufficient to maintain the company’s target surplus
• Limited to the statutory after tax ROI. Therefore should include a provision
for target statutory surplus
For stock companies, some states limit the annual transfer of earnings and surplus
from par policies.

(c) RST’s dividend rates from prior years are:

2016 2017 2018 2019

4% 4.5% 4.5% 4.5%

RST’s Dividend Actuary has given the following commentary associated with the
dividend recommendation of 7% for 2020, which will be paid out in cash:

• Investment returns outperformed previous years.

• Lapse assumption is currently determined based on the company’s
experience results. It follows a static structure for all par life
insurance products.
• Lapses have been very high in previous years but they have reduced
considerably this year; this will be considered for future dividend
setting.
• Mortality assumptions are currently determined based on the RST’s
own experience. A new mortality study was released this year which
will be applied to reserves in the next year. The dividend rate has
been reduced to smooth the results for next year's dividend.
• As a result of this expected change in the mortality assumption, there
will be changes made to the policy rating system, which are expected
to offset any resulting decrease in future dividends.

ILA LPM Fall 2020 Solutions Page 22

5. Continued

• RST entered into a new reinsurance contract this year which has
ceded away a portion of the mortality risk. The pricing team has taken
this into consideration for future pricing, but dividends have not been
adjusted in response.

Critique the recommended dividend rate based on the commentary above.

Propose changes to any assumptions if necessary.

Commentary on Question:
Overall, this part of the question was not answered well by candidates. Most
candidates were able to produce a few valid points however did not produce a
comprehensive analysis. Also, a large percentage of candidates did not answer
the second part of 5(c) to propose changes to assumptions. Candidates needed to
provide critiques specific to the context of this question to receive points. For
example, no points were rewarded for critiques related to financial reinsurance
as opposed to risk reinsurance asked in the question.

Typically, in order to meet policyholder reasonable expectation, it would be

advisable to set the dividend no less than previous years dividend.

Investment is a key driver of dividend rates. Investment returns outperforming

previous years would support the recommendation of a higher dividend rate than
previous year. That being said, 7% is a significant increase. Therefore, it would be
recommended to consider stabilizing the dividend increases with pegging or
substitution method over a number of years to avoid undue yearly fluctuation.

A single year’s decrease in lapse is inconsistent with the high lapse in previous
years. This should warrant careful investigation of causes of the sudden decrease.
It is also important to assess whether the new lapse pattern is reflective of future
trend, i.e. whether it is a one-off experience driven by a one-time event. It is
recommended to exercise caution in passing a single year lapse experience in
dividend.

The policy classifications should not change to the detriment of an in-force

cohort. Therefore, changes made to the policy rating system should create a new
dividend class for new business that do not impact dividend determination on the
in-force block.

The fact that the expected change in the mortality assumption would be offset by
policy rating system suggests there might be cross-subsidization of one
experience class by another, which should be avoided.

ILA LPM Fall 2020 Solutions Page 23

5. Continued

Risk reinsurance should be reflected in the proper dividend component as an

expense of the line of business. It is not necessary to change pricing in response to
risk reinsurance.

Dividends have been kept consistent over the past 3 years, so comparison only to
previous year could be inappropriate. Recommend comparing to past 3 years.

The pattern of the dividend over the past 3 year suggests that pegging/substitution
was possibly used to avoid dividend decreases, so caution is needed when
comparing to previous year only.

Company history is also important in setting dividends given limited information

on previous dividend scales is available.

Expenses were not included in the recommendation, but should also be reviewed.

Propose changes to any assumptions if necessary

Lapse – it is reasonable that lapse assumption is based on RST’s own experience
assuming it is credible. Lapse assumptions can differ by product and external
factors, and its materiality on financial results should be considered. A dynamic
approach is not always better, as it depends on whether the complex structure is
worthwhile. If lapse is a significant assumption for the product, a dynamic
approach is recommended. If lapse is not a significant assumption for the product,
static approach is fine.
Mortality - Mortality should also be reviewed due to changes in lapses (very high
in previous years but reduced for current year) as they are often correlated, such
as anti-selection, which would impact mortality experience. Recommend
considering industry mortality table or other outside data sources to be considered
in addition of company's own experience.

ILA LPM Fall 2020 Solutions Page 24

6. Learning Objectives:
4. The candidate will understand the various forms of traditional reinsurance, will be
able to assess how and when they are effectively used, and will be able to perform
the associated accounting (from both ceding and assuming perspectives) for basic
reinsurance transactions.

Learning Outcomes:
(4a) Evaluate and analyze traditional and advanced reinsurance transactions, and
prepare related financial statement entries.

(4b) Describe and evaluate indemnity reinsurance and evaluate its use, forms, and
requirements.

Sources:
Tiller, 4th edition, Chapter 4: Basic Methods of Reinsurance

Tiller, 4th edition, Chapter 5: Advanced Methods of Reinsurance

Commentary on Question:
The purpose of this question was to test the candidate’s knowledge of reinsurance options
and their impact on company financials. Most candidates did well on part (a) but
struggled with part (b).

Solution:
(a) Compare the effectiveness of the following types of reinsurance for each of the
company’s objectives.

(i) YRT

(ii) Coinsurance

(iii) Modified Coinsurance

(iv) Funds Withheld Coinsurance

Commentary on Question:
Candidates generally performed well on this question. Full credit was given if the
candidate answered correctly whether each of the four company objectives were
effective or ineffective, for each of the four types of reinsurance.

(i) YRT

1. Effective for reducing capital based on mortality risk.

2. Ineffective for expanding into the annuity business due to focus on

mortality risk.

ILA LPM Fall 2020 Solutions Page 25

6. Continued

3. Ineffective for achieving expense efficiencies due to small expense

allowances.

4. Effective for mitigating mortality risk.

(ii) Coinsurance

1. Effective for reducing capital based on various risks (mortality, lapse,

asset/investment, etc.).

2. Effective for expanding into the annuity business since it covers many
risks associated with annuity products.

3. Effective for achieving expense efficiencies because of the expense

allowance from the reinsurer.

4. Effective for mitigating mortality risk.

(iii) Modified Coinsurance

1. Effective for reducing capital based on various risks (mortality, lapse,

asset/investment, etc.).

2. Effective for expanding into the annuity business since it covers many
risks associated with annuity products.

3. Effective for achieving expense efficiencies because of the expense

allowance from the reinsurer.

4. Effective for mitigating mortality risk.

(iv) Funds Withheld Coinsurance

1. Effective for reducing capital based on various risks (mortality, lapse,

asset/investment, etc.).

2. Ineffective for expanding into the annuity business due to funds

withheld.

3. Ineffective for achieving expense efficiencies due to additional costs

associated with setting up trust or escrow accounts.

4. Effective for mitigating mortality risk.

ILA LPM Fall 2020 Solutions Page 26

6. Continued

(b) Life Co is entering a Mod-Co reinsurance arrangement with Reinsurance Inc.

Life Co Year 1 Year 2

Premiums 2,000 0
Expenses 50 10
Commissions 250 0
Reserves 1,500 1,800
Benefits Paid 0 50
Investment Income 10% 10%

Reinsurance Co. Year 1 Year 2

Allowance 10% 10%
Mod-Co Interest Rate 5% 5%

(i) Construct Life Co’s Gain from Operations statement for years 1 and 2
under the reinsurance agreement.

(ii) Construct Reinsurance Inc’s Balance Sheet for years 1 and 2 under the
reinsurance agreement.

Commentary on Question:
For part (i), most candidates who had a broad knowledge of financial values in
reinsurance agreements received some credit for this part, but very few
candidates achieved full credit for this question. Full credit was given if the
candidate not only provided Life Co’s gain from operations in year 1 and in year
2, but also showed their work in obtaining those values.

For part (ii), candidates generally performed poorly on this question. The most
important step in getting this correct was recognizing that the question was
asking for the Balance Sheet values of Reinsurance Inc. Candidates that
recognized this received partial credit. Full credit was given if the candidate was
able to provide the correct asset, liability, and surplus values in year 1 and year
2, but very few were able to do that.

Note the solution provided here assumes 100% coinsurance. However, since the
question did not state the coinsurance percentage, values were adjusted based on
the coinsurance percentage assumed by the candidate.

See Excel attachment.

ILA LPM Fall 2020 Solutions Page 27

7. Learning Objectives:
5. The candidate will understand the role of the Investment Actuary and the
Portfolio Management Process in the Life Insurance company context, as well as
the common forms of Fixed income securities and their uses, and the methods and
processes used for evaluating portfolio performance and asset allocation.

Learning Outcomes:
(5i) Describe the attributes of US Treasuries, Agency Debt Securities, Municipal
bonds, Corporate bonds, Private Money Market securities, Floating Rate
Agreements, Agency Mortgage Backed securities, Agency Collateralized
Mortgage securities, Interest Rate Swaps and Swaptions, Credit Derivatives and
High Yield Bonds, and the markets they are traded in.

Sources:
LIBOR and SOFR, 2019

The Handbook of Fixed Income Securities, Fabozzi, 8th Ed. , Ch. 62 - Interest-Rate
Swaps and Swaptions

Commentary on Question:
This question focused on SOFR, interest rate swaps, and calculating a swap rate.

The question tested knowledge of SOFR, and how it is different from LIBOR. Candidates
were asked to explain how those differences impacted different products.

Candidates were asked to evaluate statements about swaps, then to calculate the swap
rate based on given information.

Solution:
(a) You are given the following about GHI Financial:

• GHI sells a UL product crediting the London Interbank Offered Rate

(LIBOR) semi-annually to policyholders.
• GHI holds a 3-month British Pound to Japanese Yen cross currency
swap indexed at LIBOR
• GHI holds an overnight index swap receiving a fixed interest rate and
paying LIBOR
• GHI holds a 6-month interest swap paying LIBOR and receiving a
fixed rate semi-annually

(i) Evaluate the considerations GHI should take when moving from LIBOR
to the Secured Overnight Financing Rate (SOFR) for each item above.

(ii) Propose changes needed to apply SOFR for each item above.

ILA LPM Fall 2020 Solutions Page 28

7. Continued

Commentary on Question:
Candidates received credit for identifying the key differences between LIBOR and
SOFR, and how those impacted each of the 4 items listed. Candidates needed to
apply their knowledge of the LIBOR and SOFR differences on each of the listed
items but most candidates simply stated the differences between LIBOR and
SOFR without applying to any of the items.

For part (a)(i), candidates received full points when they evaluated the
differences between LIBOR and SOFR for each bulleted item individually. Many
candidates provided considerations but weren’t clear which consideration was
appropriate for each bullet point item listed, and so only received partial credit
once, rather than partial credit for each statement.

For part (a)(ii), candidates received credit for providing recommendations to

address issues identified in part (a)(i) for each item. Similar to the part (a)(i)
commentary, candidates needed to clearly provide recommendations for each
item, but most candidates provided general recommendations that were not tied to
any item.

(a)(i)
- UL Product crediting LIBOR semi-annually
LIBOR has different length of terms, but SOFR has only an overnight rate which
will be too volatile for setting credited rates. SOFR is a risk-free rate while
LIBOR includes a credit risk spread.
- 3-month British Pound to Japanese Yen cross currency swap
SOFR is only in USD. SOFR has only overnight rates, causing a mismatch with
the 3-month duration.
- Overnight index swap receiving fixed and paying LIBOR
Since overnight swaps are settled daily the SOFR will match. SOFR is risk-free
while LIBOR includes a credit risk spread.
- Interest rate swap pay LIBOR receive fixed semi-annually
SOFR only has overnight rates so there will be a duration mismatch with swap
payments.

(a)(ii)
- UL Product crediting LIBOR semi-annually
A credit risk premium should be added to LIBOR rates. A moving average of the
SOFR can be used to reduce the volatility.
- 3-month British Pound to Japanese Yen cross currency swap
Add a margin to account for currency differences or select a more appropriate
index such as SONIA or TONAR.

ILA LPM Fall 2020 Solutions Page 29

7. Continued

- Overnight index swap receiving fixed and paying LIBOR

As long as the credit risk is immaterial, no change is required since both are
overnight rates. Depending on counterparty risk, a credit risk premium may need
to be added.
- Interest rate swap pay LIBOR receive fixed semi-annually
Add a term premium to SOFR or use a 6-month average rate to replace LIBOR.
Depending on counterparty risk, a credit risk premium may need to be added.

(b) Critique the following statements about the 6-month interest rate swap. Justify
your answer.

A. The swap was entered into through an exchange.

B. The notional amount of the interest rate swap is the amount paid upon
agreement of the swap.

C. The timing of cash flows for both the fixed-rate payer and floating-rate
payer must be the same.

D. The way interest accrues for each period of the transaction are the same
for the fixed-rate and floating-rate payments.

Commentary on Question:
Candidates generally did well on this part, with the last statement being the most
difficult. For each statement, full credit was given if correctly indicating the
statement was correct or incorrect and for justifying the assessment. Only partial
credit was given if correctly indicating the statement being correct or incorrect
without providing justification.

- The swap was entered through an exchange.

Incorrect. Interest rate swaps are over-the-counter (OTC) instruments, which
means they are not traded on an exchange.
- The notional amount of the interest rate swap is the amount paid upon
agreement of the swap.
Incorrect. The notional amount does not move from party to party. It is used only
as a reference to determine the interest rate payments to be made.
- The timing of cashflows for both the fixed-rate payer and floating-rate payer
must be the same.
Incorrect. This is rarely the case in a swap. Parties would agree to the timing
when entering the swap.

ILA LPM Fall 2020 Solutions Page 30

7. Continued

- The way interest accrues for each period of the transaction are the same for
the fixed-rate and floating-rate payments.
Incorrect. Normally fixed rate payments are based on 30/360 day count. Floating
rate payments use actual/360.

(c) You are given the following information about the 6-month interest rate swap
paying LIBOR and receiving a fixed rate quarterly:

Notional Amount 1,000,000

Swap Settlement Date June 1, 2020
Swap Arrangement Financial Settlement of the swap
Swap Spread 15 basis points
3-Month LIBOR on June 1, 2020 4.05%
Price of 3-Month Eurodollar Futures
95.85
Contract settling on November 30, 2020
Annual forward rate on June 1, 2020 4.5%
Annual forward rate on September 1, 2020 4.75%

Calculate the following for the interest rate swap. Show your work, including
writing out the relevant formulas used in any calculations.

(i) The swap rate

(ii) The payments due to GHI at August 31, 2020 and November 30, 2020.

Commentary on Question:
Most candidates found the calculation very difficult and did not do well.
Calculating the swap rate required many steps. Partial credit was given to
candidates who demonstrated knowledge of the steps required. Very few
candidates completed all the steps correctly. Very few candidates correctly
calculated the payments.

Part (i)
1. Calculate the number of days in each payment period: 92 in first period and
91 in the second period.

2. Use the given Eurodollar futures rate to calculate the second period floating
rate. 100-95.85 = 4.15%

3. Calculate the Floating Payments as

Notional Amount * period floating rate * (# of days / 360)
First Period: $1,000,000 * 4.05% * 92/360 = $10,350.00
Second Period: $1,000,000 * 4.15% * 91/360 = $10,490.28

ILA LPM Fall 2020 Solutions Page 31

7. Continued

4. Calculate the forward discount rates as

(1 / (1 + annual forward rate * # of days / 360)
First Period: 1/(1.045*92/360)=.988631
Second Period: 1/(1.0475*91/360)=.988136

5. Calculate the Present Value of the Floating Payments using the Floating
Payments calculated in Step 3 and the forward discount rates calculated in
Step 4.
$10350*.988631 + $10490.28*.988631*.988136 = $20,480.29

6. Swap rate = Fixed interest rate such that Present Value of Fixed Rate
Payments equals the Present Value of Floating Payments
= Present Value of Floating Payments / ∑(Notional amount * # of days in
period / 360 * forward discount factor(t))
= $20,480.29 divided by
[($1,000,000*92/360*.988631) + ($1,000,000*91/360*.988631*.988136)]
= 4.10%

Part (ii)
Calculate payments due on 8/31 and 11/30

Period 1 Floating Payment = $10,350.00

Period 2 Floating Payment = $10,490.28

Fixed Payments for each period =

Notional amount * (swap rate + swap spread) * (# of days/360)

Period 1 Fixed Payment = $1,000,000 * (4.10% + .15%) * 92/360 = $10,859.65

Period 2 Fixed Payment = $1,000,000 * (4.10% + .15%) * 91/360 = $10,741.61

The payment made is Floating less Fixed

Period 1: $10,350.00 - $10,859.65 = -$509.65 (or receiving $509.65)
Period 2: $10,490.28 - $10,741.61 = -$251.33 (or receiving $251.33)

ILA LPM Fall 2020 Solutions Page 32

8. Learning Objectives:
2. The candidate will understand the theory of "Value Creation" for life and annuity
products and how to evaluate the patterns of earnings emergence under various
regulatory regimes.

Learning Outcomes:
(2c) Describe and evaluate the emergence of earnings under various financial reporting
regimes US Statutory, US GAAP, Canadian CALM and Solvency II regimes.

(2e) Describe and evaluate fundamental strategies for enhancing value through active
in-force and operational management.

Sources:
Earnings Emergence Insurance Accounting under Multiple Financial Reporting Bases,
SoA, 2015, pp. 4-6, 10-24, 45-53

Evolving Strategies to Improve Inforce Post-Level Term Profitability, Product Matters,

Feb 2015, pp. 23-29

Commentary on Question:
This question tested candidates’ knowledge of various reserving bases and how they
react to changes in assumptions and experience. Many candidates answered the question
by listing information about the different reserving bases, but did not always directly
address the question that was asked. Some candidates also gave relatively little
justification for their answers and therefore only received limited partial credit. The
graphs included in the question were also difficult for some candidates to interpret.

Solution:
(a) JKL’s actual experience from this block shows higher mortality than expected in
the first 5 years. Assume the earnings are projected again with slightly higher
expected mortality rates for years 6 to 10.

Identify which of the following will have the higher expected change in earnings
in year 6:

A. US Statutory
B. CALM

Justify your answer.

Commentary on Question:
Many candidates had difficulty using the provided Excel spreadsheet to answer
the question. Some candidates answered the question only based on the provided
earnings projection instead of considering the effects of slightly higher mortality
rates. Some candidates also discussed which basis had the higher earnings
instead of the higher change in earnings.

ILA LPM Fall 2020 Solutions Page 33

8. Continued

Based on the given values, US Statutory earnings emerge slower in earlier years
and faster in the latter half of the level term period. CALM earnings are based on
the size and pattern of the PFAD, and assumptions are re-evaluated annually with
any changes in assumptions immediately recognized in income.

When the expected mortality changes starting in year 6, US statutory reserves are
not recalculated, but CALM reserves are. US Statutory earnings in year 6 will be
reduced due to the increased claims, offset by the additional reserve release.
CALM earnings in year 6 will also be reduced due to increased claims, offset by
additional reserve release, but also reflects the full impact of the assumption
change leading to a higher recalculated reserve.

Therefore, CALM has a higher expected change in earnings compared to US

Statutory.

(b) You are given the follow graphs of the annual ratio of earnings to premium
projections for years 9-13 assuming that only the pricing shock lapse rate was
lowered in year 10 by one third:

Assume the product has no surrender value.

ILA LPM Fall 2020 Solutions Page 34

8. Continued

Identify which graph corresponds with each of the following methods:

(i) US GAAP

(ii) US Statutory

(iii) CALM

Justify your answers.

Commentary on Question:
Many candidates correctly identified that line B corresponded to a US Statutory
basis. Fewer candidates were able to distinguish between US GAAP and CALM.
Some candidates misinterpreted the graph as starting from policy issue instead of
duration/year 9 as labeled. Some candidates also misinterpreted the graph as
reflecting the dollar amount of earnings instead of the ratio of earnings to
premium.

Candidates who correctly matched the graphs to the reserving methods received
partial credit, but justification was required for full credit.

(i) US GAAP corresponds to graph C. Under US GAAP for a term product,

reserves are not recalculated due to an assumption change. Similarly to
CALM, US GAAP will reflect a significant loss at the end of the level
premium period, but there is no offset from an assumption change leading
to a reserve release.

(ii) US Statutory corresponds to graph B. At the end of the level premium

period, US Statutory will experience a significant reserve release leading
to the high ratio of earnings to premium in duration 10. US Statutory
reserves are also not recalculated based on any assumption changes and
are instead based on prescribed methodology.

(iii) CALM corresponds to graph A. CALM earnings behave similarly to US

GAAP; however, an assumption change in year 10 due to improved lapse
experience results in a higher reserve release which is immediately
recognized in income. Therefore, the negative earnings at the end of the
level premium period are less severe than US GAAP in this scenario.

(c) JKL’s inforce was priced based on the Traditional Approach of a jump to YRT
premiums at the end of the level term period. JKL just completed re-pricing
based on CALM and Solvency II using the Graded Approach. Under this
approach, the post-level-term (PLT) YRT rates will increase gradually over 5
years jumping to the original YRT schedule in year 16.

ILA LPM Fall 2020 Solutions Page 35

8. Continued

The following were the pricing assumptions used for the Traditional and Graded
Approaches:

Assumptions Traditional Pricing Graded Premium Re-Pricing

Premium (Yr 11+) (% 2015 Grade from 100% to 300% in
300%
VBT*) years 11-16
Mortality (Yr 11+) (% 2015 Grade from 100% to 300% in
300%
VBT) years 11-16
Shock Lapse Rate (Yr 10) 85% 50%
Post Level Lapse Rates (Yr 11+) Grade to 10% in year 14
CALM Mortality and Lapse
10% 10%
PfADs (Yr 11+)
50% years 1-9, Grade from 50% to 200% in years
Risk Margin
200% in Years 10+ 9-15
* Valuation Basic Table

You are given the following results for the repricing compared to the traditional
pricing:

ILA LPM Fall 2020 Solutions Page 36

8. Continued

(i) (2.5 points) Identify which graph corresponds with each of the following
methods:

• CALM
• Market Consistent (Solvency II)

Justify your answers.

ANSWER:

(ii) (2.5 points) Recommend which of the two pricing approaches you would
use to calculate the PLT premiums under each of the following valuation
bases:

• CALM
• Market Consistent (Solvency II)

Justify your answers.

Commentary on Question:
For part (i), many candidates interpreted the graph as reflecting earnings under
each basis, instead of reflecting the change in earnings attributable to the
repricing. For example, line X on the chart reflected that the repricing sharply
reduced earnings in duration 1, it did not necessarily indicate a significant loss in
duration 1.

For part (ii), a range of recommendations were acceptable and credit was given
for reasonable justifications; one such example is provided below. Some
candidates answered part (ii) by recommending a reserving basis instead of
recommending a pricing approach for each reserving basis. Such answers
received limited credit.

For both parts, many candidates did not give justifications for their answers and
therefore received only partial credit.

(i) The CALM reserve reflects the present value of future cash flows plus
provisions for adverse deviation. The Market Consistent reserve reflects
the present value of liability cash flows plus a risk margin.

Under the re-pricing, we can expect more policies to remain inforce in

years 11+ due to lower lapses under the graded premium repricing, and
therefore lower mortality due to reduced anti-selection.

ILA LPM Fall 2020 Solutions Page 37

8. Continued

Under CALM, with no changes in PFADs, the greater volume of policies

remaining inforce will lead to an increased present value of future cash
flows and therefore an increased reserve in year 1. Income emerges over
the lifetime of the business with the release of PFADs which flow into
income. Therefore, CALM corresponds to graph X.

Under Market Consistent, without additional explicit conservatism in

assumptions and with the grading of the risk margin, the results of the
repricing will show a large increase in earnings at inception, with reduced
earnings in the remaining years. Therefore, Market Consistent corresponds
to graph Y.

(ii) Under CALM, the graded pricing approach is recommended. Under this
approach, earnings are higher in every year except for year 1. In addition,
graded rates are more attractive to the policy owner, while the company
retains the rights to increase premiums up to the maximum if needed.
Experience supports that this approach results in improved earnings.

Under Market Consistent, the traditional approach is recommended. Under

this approach, earnings are higher in most years compared to the graded
approach. In addition, the company likely has confidence in this approach
due to experience, while still maintaining the flexibility to change rates as
experience emerges.

ILA LPM Fall 2020 Solutions Page 38

9. Learning Objectives:
5. The candidate will understand the role of the Investment Actuary and the
Portfolio Management Process in the Life Insurance company context, as well as
the common forms of Fixed income securities and their uses, and the methods and
processes used for evaluating portfolio performance and asset allocation.

Learning Outcomes:
(5b) Describe and evaluate how a company's objectives, needs and constraints affect
investment strategy and portfolio construction (including capital, funding
objectives, risk appetite and risk return tradeoff, tax and accounting, accounting
considerations, and constraints such as regulation, rating agency ratings and
liquidity.

(5g) Describe the principles of Liquidity Risk Management in an insurance company

portfolio management context.

Sources:
Managing Investment Portfolios, Maginn, John L. and Tuttle, Donald L., 3rd Edition,
2007 - Ch. 5: Asset Allocation (sections 2-4)

Handbook of Fixed Income Securities, Fabozzi, Frank J., 8th Edition, 2012 - Ch. 9: U.S.
Treasury Securities (pp. 194-205)

Handbook of Fixed Income Securities, Fabozzi, Frank J., 8th Edition, 2012 - Ch. 25:
Agency Mortgage-Backed Securities

Managing Investment Portfolios, Maginn, John L. and Tuttle, Donald L., 3rd Edition,
2007 - Ch. 8: Alternative Investments Portfolio Management (section 3)

LPM-162-19: Liquidity Risk Management: Best Risk Management Practices

Commentary on Question:
Commentary listed underneath question component.

Solution:
(a) Rank FAC’s asset classes from most to least liquid. Justify your ranking.

Commentary on Question:
Candidates generally performed well on this question. Most candidates were able
to recognize that cash is the most liquid asset and real estate is the least liquid
asset. Candidates lost points when they did not adequately justify the ranking.

ILA LPM Fall 2020 Solutions Page 39

9. Continued

Ranking from most liquid to least liquid:

1. Cash
2. Treasury Bonds or Agency MBS
3. Agency MBS or Treasury Bonds
4. Corporate Bonds
5. Real Estate

• Cash is by definition the most liquid asset.

• Treasury Bonds are highly liquid due to the round the clock secondary
market combined with high levels of trading.
• Agency MBS are highly liquid due to the guarantees and large issuance.
• Corporate Bonds are actively traded but do not have the guarantees of
Treasuries nor Agency MBS.
• Real Estate is an illiquid asset. It takes time to sell and is not actively
traded on most markets.

(b) Propose changes to improve FAC’s liquidity risk management.

Commentary on Question:
Candidates generally performed poorer on this part compared to the rest of the
question. Most candidates were able to recognize the following:
• FAC needs a written liquidity policy that is reviewed regularly
• FAC’s current portfolio could create liquidity risks and recommend re-
allocating from less liquid assets (e.g. real estate) to more liquid assets
(e.g. treasury bonds)
• FAC should impose surrender charges for their product
Most candidates did not write enough statements to earn full credit or did not tie
back to FAC’s specific situation.

Credit was given for any reasonable recommendation. The following list is a
sample of statements that would receive full credit for this part:
• Management needs a written policy which should be approved by senior
management and reviewed regularly.
• The company needs some quantitative tools for evaluating risks and more
useful qualitative tools.
• FAC should impose surrender charges. The lack of surrender penalties in
product design creates liquidity risks.
• Sales of FAC's current portfolio of illiquid corporate bonds could be
problematic as a cash flow source.
• Similarly, the lack of liquidity in real estate versus Treasuries/MBS should
be considered.
• IFA distribution networks are prone to greater panic withdrawal risk than
tied agents and direct marketing distribution.

ILA LPM Fall 2020 Solutions Page 40

9. Continued

• The company should manage its access to financial markets and have an
ongoing presence in its funding channels.
• FAC's plan to use capital to provide for liquidity risk is an ineffective
means of managing the risk.

(c) Critique the following statements:

A. Due to current economic conditions, Treasury bonds will outperform

corporate bonds over the next six months. While long term expectations
are well grounded, FAC needs an immediate revision to its strategic asset
allocation to take advantage of the current pricing anomaly.

B. Mortgage-backed security valuation requires sophisticated modeling of

prepayment rates. FAC has built a model with 53 parameters that fits
historical data almost perfectly, which gives a significant advantage over
the market.

C. Adding Real Estate to FAC’s strategic asset allocation improves risk

diversification and increases the liquidity and Sharpe ratio of the
portfolio.

Commentary on Question:
Part c) was very well done. Most candidates were able to:
- Indicate that the SAA portfolio should not be changed due to short-term changes
in market expectations.
- Suggest that the proposed model needs to be simplified.
- Show an understanding of the impact that adding real estate to the asset
allocation has on risk diversification and liquidity.
However, some candidates were unsure of the impact that adding real estate
would have on the Sharpe ratio.

Statement A)
The strategic asset allocation (SAA) is based on long-term expectations of risk
and target return, and should not impacted by short-term changes in market
expectations. The policy portfolio should only be revised due to changes in the
investor's long-term market forecasts, not due to short-term projections.

Statement B)
Mortgage-backed security valuation does requires sophisticated modeling.
Models with the most useful future projections should be simple and use far fewer
than 53 variables. A model using too many variables may fit historical data very
well (ie. overfitting), but likely will not provide accurate future projections.

ILA LPM Fall 2020 Solutions Page 41

9. Continued

Statement C)
- Real Estate is an important diversifier as it responds differently than stocks or
bonds to various market conditions.
- Real estate is an illiquid asset, so adding real estate to FAC’s strategic
allocation would reduce the overall liquidity of the portfolio.
Sharpe ratio is affected by both the expected return and risk. Since adding real
estate improves diversification, the denominator will be smaller, and the Sharpe
ratio should increase.

ILA LPM Fall 2020 Solutions Page 42

10. Learning Objectives:
1. The candidate will understand the designs and risks of the common life and
annuity products and features, as well as the methods and metrics used to design
and price these products.

Learning Outcomes:
(1m) Describe and apply the methodology for evaluating pricing sensitivities using a
"Pricing Surface".

(1q) Describe and evaluate the types of assumptions commonly used in actuarial
pricing and product development.

Sources:
LPM-107-07: Experience Assumptions for Individual Life Insurance and Annuities

The Use of Predictive Analytics in the Development of Experience Studies, The Actuary,
2015 Predictive Modeling for Life Insurance: Ways Life Insurers Can Participate in the
Business Analytics Revolution, Product Matters, 2018
Evolving Strategies to Improve Inforce Post-Level Term Profitability

Commentary on Question:
Commentary listed underneath question component.

Solution:
(a)
(i) Describe the pricing goals for the “shock” premium rate for year 6.

(ii) Calculate the 95th percentile confidence interval of the policy year 5 lapse
rate. Show all work, including writing out relevant formulas used in any
calculations.

Commentary on Question:
Candidate generally performed well on this question.

In part (ii), various errors in calculating the standard deviation were common.

(i) The goal for the shock premium is to ensure appropriate pricing:
• As underwriting will have worn off, an increase in premium is needed to
cover increased mortality risk.
• The jump in premium will cause anti-selection – only policyholders who
cannot obtain cheaper coverage elsewhere will persist, worsening
mortality deterioration.
• Goal is to increase the premium enough to cover increased mortality risk,
but not too much which would drive all good risks away.

ILA LPM Fall 2020 Solutions Page 43

10. Continued

Some companies may have additional goals such as replacement or

conversion to permanent products. Some companies may choose to use an
aggregate rate design which is simpler to administer than a multi-class
structure.

(ii) Expected # of lapses = expected lapse rate * policy exposure

= 90% * 8300 = 7470

Variance = Exposure * expected lapse rate * (1 – expected lapse rate)

= 8300 *90% *10% = 747

95th CI of # of lapses = Expected # lapses +/- 1.96 * Std Deviation of # lapses

= 7470 +/- 1.96*(747^0.5)
= (7416, 7542)
95th CI of lapse rate = 7470/8300 +/- 1.96*(747^0.5)/8300
=(89.4%, 90.6%)

(b) Recommend lapse assumptions for policy years 5 and 6 for the upcoming product
repricing. Justify your assumptions.

Commentary on Question:
The candidates who performed well on this question tended to take one of two
approaches: (1) apply credibility theory to derive new lapse assumptions or (2)
calculating the 95% CI for year 6 and recommending lapse assumptions within
the 95% CIs for both years

Other reasonable answers were accepted, as long as candidates justified their

answer.

Credibility Approach:

Applying limited fluctuation and using 5% error rate:

Z = min (1, (0.05*(# lapses)^0.5)/1.96)

Year 5 Z = min (1, 0.05*(7835^0.5)/1.96) = 1

Year 6 Z = min (1, 0.05*(394^0.5)/1.96) = 0.506

Year 5 is fully credible, so the actual lapse experience can be used.

Year 6 is not fully credible, so the actual lapse experience must be blended with
industry or other data.

ILA LPM Fall 2020 Solutions Page 44

10. Continued

Recommend:
Year 5 = 7835/8300 = 94.4%
Year 6 = 0.506*(394/450) + (1-0.506)*80% = 83.8%, using the existing
assumption in lieu of industry data

CI Approach:

Calculate the CI for Year 6:

Expected # of lapses = expected lapse rate * policy exposure

= 80% * 450 = 360

Variance = Exposure * expected lapse rate * (1 – expected lapse rate)

= 450 *80% *20% = 72

95th CI of # of lapses = Expected # lapses +/- 1.96 * Std Deviation of #

lapses
= 360 +/- 1.96*(72^0.5)
= (343, 377)
95th CI of lapse rate = 360/450 +/- 1.96*(72^0.5)/450
=(76.3%, 83.7%)

Actual lapses for both years 5 and year 6 are above the 95% CI, indicating that the
lapse assumption is too low. The lapse assumption should be increased to the
higher end of the CI of 90.6% for year 5 and 83.7% for year 6.

(c) LMN is developing lapse assumptions for a new 10-year level term product,
which is annually renewable after year 10. LMN has not sold 10-year level term
products in the past. The Pricing Actuary has set the 10-year level term lapse
assumptions based on the 5-year level term experience

Critique the Pricing Actuary’s lapse assumption.

Commentary on Question:
Most candidates recognized that the Pricing Actuary’s recommendation was
inappropriate. Candidates who performed well were able to clearly articulate
why the recommendation was inappropriate and suggest alternatives.

This recommendation is not appropriate.

• Shock lapses will occur after year 10, not after year 5. The amount of the
shock lapse may be different.
• Industry data shows that lapses tend to be lower during the level term
period for longer term products, so the level term lapses for the 10 year
product will likely be lower than the 5 year product.

ILA LPM Fall 2020 Solutions Page 45

10. Continued

• Lapse rates on level term plans issued recently tend to be much lower
than older plans from the 90s, so the data from LMN’s existing 5-yr term
products may not be applicable to a newly designed product.
• Other product features or differences in design may affect lapse rates,
such as differences in policy size, distribution channel, ability to convert
to permanent product.
• It would be more appropriate to source industry data or consult with a
reinsurer to obtain appropriate and relevant data.

(d) The experience studies actuary recommends use of a predictive analytics model to
develop lapse experience studies for the 5 year and 10 year level term products
instead of LMN’s traditional approach.

(i) (2 points) Describe the different methods and steps used in developing a
predictive analytics model versus LMN’s traditional approach for
experience analysis studies.

(ii) (2 points) Evaluate the actuary’s recommendation. Justify your answer.

Commentary on Question:
Most candidates performed moderately well on this question.
For part (i), a common error was listing advantages and disadvantages of
predictive analytics and/or traditional approaches instead of explaining the steps
and methods of each. For part (ii), candidates could agree or disagree with the
recommendation, but had to provide pros/cons of predictive analytics and justify
their answer to receive full marks.

ILA LPM Fall 2020 Solutions Page 46

10. Continued

(i)

Step Predicative Analytics Traditional

Data Collection & • Uses a number of • Mostly relies on past

Validation variables that experience data.
traditional approaches
would not consider.
• May require sourcing
external data (e.g.
credit scores)
• No limit on number of
variables included
• Data needs to be
partitioned into
training and validation
Exploratory Data Analysis • Analyze the properties
of each variable
Variable Transformation • Attempt to mitigate • Preferred approach is
data imperfections/ generally smoothing.
Model Building • Select the form of the • Generally, no different
lapse model (e.g. models are used
GLM). • A/E is assessed for
credibility and a new
lapse rate is
determined.
Model Validation • Statistical techniques • More of a reasonability
are used to validate the check.
model.
• Use holdback data
Final Calibration • Refit the model as
needed
Implementation and • Results of lapse model • Results are also
Ongoing Monitoring could be used as monitored but not used
scoring engine for in as many ways
another risk model

(ii)
Predictive analytics has many advantages:
• Allows the examination of relationships between variables; correlations
between lapse factors can be studied statistically
• Provides better insight into the interactions of various factors
• Supported by statistical tests and theory
• Trends can be captured more readily

ILA LPM Fall 2020 Solutions Page 47

10. Continued

• Isolated the true effect of each variable, standardizing the effect of other
variables
• Allows use of factors not used in traditional methods

However, there are also disadvantages:

• More complicated. Traditional approaches to lapse studies are well established
and easier to explain to management.
• Requires specific expertise to implement, which LMN may not have.
• More time consuming (and therefore more expensive)
• Pricing models may not be able to handle more refined assumptions that
would result from an predictive analytics approach
• Requires a lot of data, which may be difficult to acquire, especially given
LMN’s lack of experience with 10-year term.

Predictive analytics can be powerful, but LMN should evaluate the costs (of
obtaining data and developing data) vs the expected benefits and ensure the more
complex assumptions that would result can be used in the pricing model before
proceeding.

ILA LPM Fall 2020 Solutions Page 48