ST8 Pu 14 PDF

ST8 P U 14
CMP Upgrade 2013/14
ActEd Study Materials: 2014 Examinations
Subject ST8
Contents
CMP Upgrade 2013/14
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ISBN 978-1-4727-6443-0
The Actuarial Education Company

9HSLERC*hgeeda+ IFE: 2014 Examinations
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for the exclusive use of the purchaser. The copyright is owned
by Institute and Faculty Education Limited, a subsidiary of
the Institute and Faculty of Actuaries.
Unless prior authority is granted by ActEd, you may not hire

out, lend, give out, sell, store or transmit electronically or
photocopy any part of the study material.
You must take care of your study material to ensure that it is

not used or copied by anybody else.
Legal action will be taken if these terms are infringed. In

addition, we may seek to take disciplinary action through the
profession or through your employer.
These conditions remain in force after you have finished using

the course.
IFE: 2014 Examinations The Actuarial Education Company

ST8: CMP Upgrade 2013/14 Page 1
Subject ST8
CMP Upgrade 2013/14
CMP Upgrade
This CMP Upgrade lists all significant changes to the Core Reading and the ActEd
material since last year so that you can manually amend your 2013 study material to
make it suitable for study for the 2014 exams. It includes replacement pages and
additional pages where appropriate. Alternatively, you can buy a full replacement set of
up-to-date Course Notes at a significantly reduced price if you have previously bought
the full price Course Notes in this subject. Please see our 2014 Student Brochure for
more details.
This CMP Upgrade contains:
All changes to the Syllabus objectives and Core Reading.
Changes to the ActEd Course Notes, Series X Assignments and Question and
Answer Bank that will make them suitable for study for the 2014 exams.
The Actuarial Education Company IFE: 2014 Examinations

Page 2 ST8: CMP Upgrade 2013/14
1 Changes to the Syllabus objectives and Core Reading
1.1 Syllabus objectives
There have been no changes to the syllabus objectives.
1.2 Core Reading
Chapter 3
Page 37
A new paragraph of Core Reading has been added, which discusses the use of
telematics in motor business. This should be added after Question 3.17 and reads as
follows:
It should be noted that, at the time of writing, there is in many countries a

gradual increase in the use of telematics, whereby the driving behaviour and
other factors can be monitored through the use of a black box. This makes
some of the above factors measurable, and the results can be used to help price
the policy.
Chapter 5
Page 1
The second paragraph in Section 0.1 now reads:
Reinsurers, in turn, provide reinsurance to insurance companies and reinsurance

companies (retrocession).
Chapter 7
Page 20
A new discussion on the EU Gender Directive has been added.
Cross out the text below Question 7.9 on page 20 and add new pages 20a and 20b
provided below.

Chapter 9
Page 9
A new list has been added after the second paragraph on page 9. This reads:
Reserves booked will usually be greater than best estimate due to:
smoothing of results
difficulty in setting reserves, particularly reinsurance recoveries
requirements of regulatory bodies
peer pressure.
Page 13
The sentence under the exchange rates sub-heading should now read:
If the insurer holds investments in foreign currencies, which differ from those
underlying the liabilities, then future exchange rates will be a further source of
uncertainty.
Pages 17-18
A new portion of Core Reading has been added, which discusses uncertainty arising
from the treatment of large losses.
We recommend that you remove pages 1718 from your Course Notes and use
replacement pages 17, 18, 18a and 18b provided below.
Page 28
A new sentence of Core Reading has been added at the end of the section on broker
mergers. This reads:
This can be a particular issue for commercial risks where both insureds and
brokers are far bigger than the insurers.

Chapter 10
Page 4
The first sentence of the third paragraph now reads:
Industry-wide (or industry-source) data is collected and compiled by member

offices of particular organisations, for example, the ABI (Association of British
Insurers) and Lloyds of London in the UK.
Page 7
A new use of data has been added to the list of bullet points:
catastrophe modelling.
Page 10
Two new users of data have been added to the list of bullet points:
risk management
catastrophe modelling.
Page 11
The second example now reads:
Example
In the UK, an insurer should have kept at least enough data to be able to compile
the statutory returns to the PRA (Prudential Regulation Authority). There are
similar requirements in some other countries.
Page 15
The last sentence above Section 3.3 now ends:
... say, half the retention.

Page 16
The last sentence of the example now reads:
The former will provide claims details to be entered onto the insurers systems
or onto bordereaux, while claims from the latter will be entered by the insurers
own staff.
Page 17
A new sentence has been added before the first paragraph of ActEd text. This reads:
Both premiums and claims information may be bulk figures, and thus policy and
claims details are hard to access.
The fifth paragraph now reads:
It may be time consuming for staff to enter such data into a computer system
and so only major losses may be broken out from claims bordereaux, with the
residual being entered as a bulk item. It is quicker to integrate data received
electronically into the system.
Page 18
The last sentence in the paragraph discussing length of tail now reads:
This is particularly true of classes that are subject to significant delays in claim
notification or slow loss development.
The last sentence on the page now reads:
But the fact that the information will vary from risk to risk does not lend itself to
systematic data capture; often this is the case with London Market data.
Page 21
A new sentence has been added after Question 10.8. This reads:
Clear links are needed between underwriting and claims databases eg via policy
reference numbers.

Page 22
The last paragraph now reads:
Written premiums are the premiums an insurer expects to receive over the
duration of the policy. Written premiums may be before or after commission.
The insurer should calculate the net written premiums by deducting any
reinsurance premiums from the gross premiums.
Page 26
The second list of bullets now includes a third point:
the speed of notification.
Page 28
The fourth paragraph from the bottom of page 28 has been deleted.
The third paragraph from the bottom of page 28 now reads:
In the London Market, policies are often coinsured by a number of different

insurers. In these cases, the lead insurer will normally be responsible for
handling the claim (although the second on the slip may also be involved) and
will advise reserves to the following insurers. It is common for following
insurers to use the reserve advised by the leader, although some insurers do
alter the reserve for contentious claims where there are issues such as policy
coverage.
Page 29
The last sentence of the second paragraph now reads:
This is likely to occur some time after the original claim payments are made and
the amounts are normally recorded as negative claim payments with a code to
identify the type of receipt so that claim severities can be better assessed.
Page 30
Another bullet point has been added to the list of reasons for reopening claims:
For a claim made by a minor who can reclaim on attaining the age of
eighteen.

Page 31
A new sentence has been added to the end of the second paragraph, which reads:
Inwards claims are likely to have a catastrophe indicator and recoveries may be
proportional.
A new discussion has been added to the end of the section on reinsurance recoveries.
This reads:
The amount of the reinstatement premium would therefore be allocated to the claim(s)
that had necessitated the use of the reinstatement cover.
It is unlikely that one will allocate IBNR and paid claims to individual risks except
for large London Market contracts.
Indeed, it is very difficult to allocate IBNR to an individual claim because, by

definition, we dont yet know about it and therefore cant know which claim to allocate
it to.
Page 39
A new sentence has been added to the end of the section on check digits. This reads:
The policy number is often used as a link between different databases,

eg claims system and policy or client system.
Chapter 18
Page 4
The second sentence of the example should now read:
The population of motorists is heterogeneous and it is believed to be made up

of equal numbers of:
Page 26
In the section on the square root rule, the three occurrences of nF should be changed to
nN .

Page 28
In equation (18.15) and the sentence introducing this equation, change nF to nN .
Page 29
In equation (18.16), change all four occurrences of nF to nN .
Page 30
In the sentence immediately preceding the graph and the sentence immediately
following the graph, change nF to nN .
Chapter 19
Page 8
The third paragraph from the bottom of the page has been expanded to read:
This is broadly equivalent to the economists split between fixed and variable
expenses but, in practice, there is not a clear dividing line between these two
categories.
Page 19
A new paragraph has been added immediately after the rate change formula, as follows:
But this can be hard to derive. We need to remove / standardise all other
factors, eg changes in exposure, changes in commission charge, changes in
period covered, inflating asset values.
Page 20
An additional sentence has been added at the end of the first paragraph in the section on
pricing a standard risk:
This works best where across the board changes to rates are made or where a
representative portfolio of risks is assessed.

Page 22
New wording has been added immediately after the rate change formula, as follows:
although the individual detail will be lost when individual rate changes are
grouped in this way.
A new discussion about the reasons why an insurer monitors portfolio movements has
been added. Additional pages 22a and 22b, provided below, should be inserted into
your Course Notes.
Page 25
In the first paragraph of the new business discussion, the second sentence has been
expanded. It now reads:
Delays occur because of internal processing delays or, more significantly,

intermediary delay, particularly where underwriting authority is delegated.
Chapter 21
Page 3
In the last sentence of the third paragraph, replace the word providing with the word
utilising.
Glossary
Page 1
The final phrase has been deleted. This was:
an example being the Claims Reserving Manual published by the Faculty and
Institute of Actuaries.
Page 7
The definition of a bordereau has been updated to read:
A detailed list of premiums, claims and other important statistics provided by

ceding insurers to reinsurers (or by coverholders to insurers in direct
insurance), so that payments due under a reinsurance treaty (or delegated
authority schemes in direct insurance) can be calculated.

Page 10
The definition of a claim cohort has been updated to read:
A group of claims with a common period of origin. The period is usually a

month, a quarter or a year. The origin varies but is usually defined by the
incident date of a claim, the date of reporting of a claim, the date of payment of a
claim, or the date when the period of cover to which a claim attaches
commenced.
Page 14
The definition of deferred acquisition costs has been updated. The first sentence now
reads:
Acquisition costs relating to unexpired periods of contracts in force at the

balance sheet date.
Page 18
In the definition of experience rating, the end of the first paragraph now reads:
... a collar or corridor.
Page 19
The definitions of Financial Services and Markets Act 2000 (FSMA)* and Financial
Services Authority (FSA)* have been deleted.
Page 20
A new definition of fronting has been included. This reads:
Fronting
Fronting occurs when an insurer, acting as a mere conduit, underwrites a risk

and cedes all (or nearly all) of the risk to another insurer which is technically
acting as a reinsurer. The ceding or fronting insurer will typically receive a fee
for its involvement to cover its expenses and profit.
In insurance the term fronting may also be used to describe the process
whereby an individual effects a policy for him/herself but tries to save money by
putting the policy in someone elses name.

Page 39
In the definition of required solvency margin, FSA has been changed to PRA.
Page 46
The definition of Value at Risk has been changed to:
Value at Risk (VaR)
In financial mathematics and financial risk management, Value at Risk (VaR) is a

widely used measure of the risk of loss. For a given probability and time
horizon, VaR is defined as a threshold value such that the probability that the
loss on the portfolio over the given time horizon exceeds this value is the given
probability level.
Pages 48 52
The following items have been added to the list of abbreviations:
ATAFs Age to age factors

ATUFs Age to ultimate factors
BAU Business as usual
FCA Financial Conduct Authority
ORSA Own Risk and Solvency Assessment
PRA Prudential Regulation Authority
SCR Solvency Capital Requirement
TAS Technical Actuarial Standard
The following items have been deleted from the list of abbreviations:
FSA Financial Services Authority

GRIP General insurance premium Rating Issues working Party
GRIT General insurance Reserving Issues Taskforce

2 Changes to the ActEd Course Notes
Chapter 2
Page 19
The last sentence now reads:
For example, the European Court of Justice recently ruled that a persons sex can no
longer be used to calculate insurance premiums.
Chapter 3
Page 37
A new paragraph of ActEd text has been added, to follow the new Core Reading on the
use of telematics in motor business. It reads as follows:
The term black box here doesnt refer to a box that is black (although it might be!).
Rather, it is a device or system that is placed in a motor vehicle to monitor the way in
which the vehicle is driven. It can measure speed, acceleration, braking, etc as well as
monitoring exactly when the vehicle is driven. Its called a black box because we will
generally know very little about its inner workings.
Chapter 6
Page 12
The first sentence of Question 6.7 should read:
With reference to self-assessment Question 6.3:
Chapter 7
Page 19
The explanation of the second bullet point in Section 3.2 has been expanded, to read:
For example, the authorities in some US states, eg Massachusetts, set the personal
motor premium rates that must be charged. Some states require that rates are filed (sent
to the relevant state department for approval) prior to an insurer using them. An
authority could ....

Page 19
A new explanation has been added to the third bullet point in Section 3.2. Add a new
sentence which reads:
For example, under the EU Gender Directive, European insurers are no longer allowed
to use gender as a rating factor. (This is discussed further below.)"
Page 20
A new ActEd discussion has been added to supplement the new Core Reading on the
EU Gender Directive.
As stated above, cross out the text below Question 7.9 on page 20 and add new pages
20a and 20b provided below.
Chapter 9
Page 17
A new ActEd discussion has been added to supplement the new Core Reading on the
uncertainty arising from the treatment of large losses.
As stated above, we recommend that you remove pages 1718 from your Course Notes
and use replacement pages 17, 18, 18a and 18b provided below.
Chapter 10
Page 11
The final paragraph has been re-written as follows:
The PRA is one of the successors to the FSA (Financial Services Authority), with
effect from 1 April 2013. Amongst other things, it is responsible for the supervision
and regulation of insurance companies in the UK.

Page 31
As stated above, a new discussion has been added to the end of the section on
reinsurance recoveries. This reads:
The amount of the reinstatement premium would therefore be allocated to the claim(s)
that had necessitated the use of the reinstatement cover.
It is unlikely that one will allocate IBNR and paid claims to individual risks except
for large London Market contracts.
Indeed, it is very difficult to allocate IBNR to an individual claim because, by

definition, we dont yet know about it and therefore cant know which claim to allocate
it to.
Page 55
The final paragraph in the section on uses and users of data now reads:
The full development team for a computer system should include senior management,
accountants, underwriters, claims managers, marketing, investment, computing staff,
risk management staff, catastrophe modellers and reinsurers, as well as actuaries.
Page 60
Two more points have been added to Solution 10.5. These are:
Risk management: monitoring the size and nature of risks written, identifying
aggregations of risk, implementing risk controls
Catastrophe
modelling: assessing and quantifying catastrophe risks.
Chapter 16
Page 19
The subscripts to the Xs towards the bottom of the page have been changed from
X1 j , X 2 j , X 3 j and X 4 j to X i1 , X i 2 , X i 3 and X i 4 .

Chapter 18
Page 20
sX
In the sentence in the middle of the page, change the word variance, describing ,
N
to standard deviation.
Page 26
In the section on the square root rule, the following sentence can be deleted:
Note that nF is equivalent to the nN encountered earlier in this chapter.
Page 38
Delete the second sentence of the penultimate paragraph.
Page 47
In the summary of partial credibility, replace all five occurrences of nF with nN .
Page 54
A number of changes have been made to Solution 18.8. Remove pages 53-54 from your
Course Notes and use replacement pages 53-54 provided below.
Chapter 19
Page 22
As stated above, a new discussion about the reasons why an insurer monitors portfolio
movements has been added. Additional pages 22a and 22b, provided below, should be
inserted into your Course Notes.

3 Changes to the Q&A Bank
Part 2
In Solution 2.21 part (i), the last sub-bullet point within the first main bullet point
should now read:
other (underwriters, reinsurers, claims, investment, computing, risk managers,

catastrophe modellers).
Part 5
Question 5.6 part (i) is now worth 4 marks, with the total for the question changing to 6
marks. The solution to part (i) has been expanded so you should replace pages 3 to 6
with replacement pages 3 to 6 provided below.
Part 6
In the penultimate point of Solution 6.4, change the word reinsurer to insurer.

4 Changes to the X Assignments

This section provides details of material changes that have been made to the
2013 X Assignments, so that you can continue to use these for the 2014 exams.
However, if you are having your attempts marked by ActEd, you will need to use the
2014 version of the assignments.
A comment has been added to each solution detailing which part of the course it covers.
Assignment X1
Solution X1.2
In part (i), the first [] mark has been changed to [1].
Solution X1.4
In part (a), the [] mark for the third point has been changed to [].
Solution X1.6
In the third bullet point of the second set of bullet points in part (ii)(b), delete the words
(and whether missiles are covered).
Solution X1.7
There have been a number of changes to the solution to part (ii). Cross out all of the
part (ii) solution on pages 8 and 9 and insert new replacement pages 9 and 9a as
provided below.
Solution X1.8
The second point of part (ii) is now worth [1] mark.
Assignment X2
Solution X2.3
The [] mark for the second point has been changed to [].

Solution X2.7
There have been a number of changes to this solution. Remove pages 7 and 8 and
replace with new pages 7 and 8 provided below.
Solution X2.9
In part (ii), the [] mark for the first point has been changed to [1].
Solution X2.10
The second point in part (i) has been re-written. It now reads:
Volumes of business will be uncertain. It will be difficult to predict how many people
will own pubs, and hence require this type of insurance. The level of competition will
also be uncertain, which will further increase the uncertainty of business volumes. [1]
Assignment X5
Solution X5.2
The first [1] has been split into two [] marks: the first for the calculation of F ( y ) and
the second for the calculation of y .
Solution X5.6
In part (ii), the fourth point has been split into two separate points as follows:
In particular, brokers may not be getting enough commission and so do not have the
motivation to complete a sale. []
A review of the commission levels and perhaps increasing the initial commission may
improve the strike rate. The commission should target the more effective brokers. [1]
Solution X5.7
Under the application of judgement heading, the first point is now worth [1].
Solution X5.8
Change all occurrences of nF to nN and all occurrences of PF to PN .

Solution X5.9
In part (iii), in the section on pricing a standard risk, add a new point after the first one
as follows:
This method works best where changes to rates are made across the board or where a
representative portfolio of risks is assessed. []
Still in part (iii), in the section on measuring rate changes on individual renewals, add a
new point just before the final point as follows:
In addition, the individual detail will be lost when individual rate changes are grouped
in this way. []
Assignment X6
Solution X6.6
The mark for the second point in part (iii) has been increased to [1].
Solution X6.8
In part (i), under the burning cost approach, the seventh and eighth bullet points have
been combined into one bullet point but with each sentence being worth [1] mark. This
now reads:
We could, for example, take the average of each years exposure-adjusted

losses to the layer to arrive at an estimate of the loss cost for the year being
priced. [1]
Alternatively, we could divide each years losses to the layer by the exposure to
give a loss rate for each year, then take the average and apply to the exposure for
the year being priced. [1]

5 Other tuition services

In addition to this CMP Upgrade you might find the following services helpful with
your study.
5.1 Study material
We offer the following study material in Subject ST8:

ASET (ActEd Solutions with Exam Technique) and Mini-ASET
Flashcards
Mock Exam A and the Additional Mock Pack
Revision Booklets
For further details on ActEds study materials, please refer to the 2014 Student
Brochure, which is available from the ActEd website at www.ActEd.co.uk.
5.2 Tutorials
We offer the following tutorials in Subject ST8:

a set of Regular Tutorials (lasting three full days)
a Block Tutorial (lasting three full days)
For further details on ActEds tutorials, please refer to our latest Tuition Bulletin, which
is available from the ActEd website at www.ActEd.co.uk.
5.3 Marking
You can have your attempts at any of our assignments or mock exams marked by
ActEd. When marking your scripts, we aim to provide specific advice to improve your
chances of success in the exam and to return your scripts as quickly as possible.
For further details on ActEds marking services, please refer to the 2014 Student
Brochure, which is available from the ActEd website at www.ActEd.co.uk.

6 Feedback on the study material

ActEd is always pleased to get feedback from students about any aspect of our study
programmes. Please let us know if you have any specific comments (eg about certain
sections of the notes or particular questions) or general suggestions about how we can
improve the study material. We will incorporate as many of your suggestions as we can
when we update the course material each year.
If you have any comments on this course please send them by email to ST8@bpp.com
or by fax to 01235 550085.

All study material produced by ActEd is copyright and is sold
for the exclusive use of the purchaser. The copyright is owned
by Institute and Faculty Education Limited, a subsidiary of
the Institute and Faculty of Actuaries.
Unless prior authority is granted by ActEd, you may not hire

out, lend, give out, sell, store or transmit electronically or
photocopy any part of the study material.
You must take care of your study material to ensure that it is

not used or copied by anybody else.
Legal action will be taken if these terms are infringed. In

addition, we may seek to take disciplinary action through the
profession or through your employer.
These conditions remain in force after you have finished using

the course.

ST8-07: General insurance markets Page 20a
EU Gender Directive
The EU Gender Directive was passed in 2004, being aimed at implementing the
principle of equal treatment between men and women in the access to and
supply of goods and services.
In its original form, the EU Gender Directive included an opt-out in respect of

financial and insurance products provided that certain conditions were met. In
March 2011, the European Court of Justice gave its ruling on the legality of the
insurance opt-out provision, concluding that it is not valid and should therefore be
removed with effect from 21 December 2012. From that point, insurance
companies have no longer been able to use gender as a rating factor.
However, insurance companies are careful to avoid the use of proxy rating
factors (ie highly correlated to gender) that might be deemed to be indirect
discrimination and thus also not permitted.
Clearly, the inability to differentiate between gender when setting premium rates
is having significant implications for insurance pricing, particularly for motor
insurance where there are material observed differences in claims experience
according to gender at certain ages.
Each insurer is likely to set premium rates based on the expected mix of business by
gender but there is the risk that the mix of male / female policyholders turns out not to
be as expected. The introduction of this legislation has therefore increased the
uncertainty of insurers claims experience and profitability.
It is not yet clear how premium rates or underwriting practices have changed as
a result of the ruling. However it is likely that premiums have not simply met in
the middle, but that there have been additional contingency loadings for the risk
of business mix by gender not being as expected within the unisex pricing.
In other words, this legislation has also led to increased uncertainty in premium rates, at
least in the short term, and hence higher risk margins being charged by insurers.
Other possible regulations
Other regulations that could be imposed on general insurers include:

requirement to provide detailed reports and accounts at prescribed intervals
requirement to purchase reinsurance
requirement to hold a claims equalisation reserve
limits on contract terms
advertising restrictions

Page 20b ST8-07: General insurance markets
prescription to hold certain assets.
Regulation is considered further in Subject ST7.

ST8-09: Risk and uncertainty in pricing Page 17
3.2 Incorrect dependencies
A number of the variables in the model will be correlated with one another; for
example, interest rates and claims inflation.
Question 9.11
How might interest rates and claims inflation be correlated?
It is important that the dependencies are programmed correctly. The

correlations can be regarded as additional parameters, and it is essential that
they are not overlooked.
3.3 Change in case estimate reserving philosophy
Reserving philosophy within a company will change from time to time.
Example
If claims handlers have under-reserved a case in the recent past, they may be
inclined to overestimate future claims to compensate.
There may also be changes in reserving philosophy following a change in senior

personnel.
This could involve a change in reserving methods, or a change in the basis used for the
reserve estimates (within an acceptable range).
If changes in reserving philosophy are known, it may be possible to make

adjustments.
3.4 Large and exceptional claims
Large claims
Large claims can be expected to have different frequency and severity

distributions to attritional and catastrophe claims. They are also likely to have
different development patterns. There may also be differences in development
pattern based upon the type of large claim.

Page 18 ST8-09: Risk and uncertainty in pricing
Example
A large windstorm claim may develop at a different rate to a large flood claim,
although both types of claim may be experienced in a property book.
It is normal practice to remove large claims from the development and project
these separately.
Uncertainty may also arise in how a large claim is defined. They could be
defined as claims over a particular threshold (possibly with a different threshold
for different perils, often set to achieve sufficient data and with an eye on the
reinsurance programme), or large claims may be a subjective management
decision.
If the threshold for what constitutes a large claim is too low, then a large quantity of
data will be excluded from the attritional claims triangulation, and this will result in the
triangulation data (and the reserve estimates) being less credible.
However, if the threshold is set too high, then more large claims will be included in the
attritional triangulation data, and this will increase the volatility of the projection.
In practice, the definition of a large claim might be set at the retention limit for the
non-proportional reinsurance programme. This would make a projection of net of
reinsurance claims much easier. (Reinsurance reserving is discussed in detail in
Subject ST7.)
If the threshold method is chosen, there is the additional uncertainty as to

whether this increases over time, and at what rate. Effectively the threshold
would decrease going backwards through cohorts.
An insurer is likely to increase the definition of what constitutes a large claim

periodically, in order to allow for claims inflation and maintain the real value of the
threshold. Hence prior origin years might well have a lower threshold than the current
origin year. The rate of inflation to apply to the threshold limit is likely to be uncertain
and will often differ from the rate at which attritional claims inflate.
On some occasions, there may be an absence of large reported claims, and the
reserving actuary may wish to add a loading to reflect this fact. This will give
rise to additional uncertainty.

ST8-09: Risk and uncertainty in pricing Page 18a
Catastrophes
Catastrophic losses can take the form of one immense loss, such as an oil-rig explosion.
Alternatively, there may be many smaller insured losses, all stemming from a common,
identifiable event such as a hurricane.
Catastrophes are typically hard to predict, so are hard to allow for when pricing.
Catastrophe modelling is discussed later in this subject.
One way to reduce the impact of catastrophic losses is to write business in a wide range
of geographical locations and across many classes. Catastrophe reinsurance will also
help (more of this later in the course).
Latent claims
Catastrophic claims can also result from sources that were unknown, or for which a
legal liability was not expected, at the time of writing the business. The cost of such
claims cannot be calculated with any accuracy for the purpose of setting premiums.
The first problem with latent claims is that it is impossible to know where the potential
claim is lurking. Secondly, if the claim does materialise, the future claim cost is
completely unknown.

Page 18b ST8-09: Risk and uncertainty in pricing
This page has been left blank so that you can slot the replacement
pages into your Course Notes.

ST8-18: Credibility theory Page 53
Solution 18.7
We know the probability that the observed aggregate loss is within a proportion k of
the mean mS is:
P = Prob [ mS - k mS S mS + k mS ]
m m
= Prob - k S z k S
s S s S
where z =
( S - mS ) is a standard normal variable. (This assumes that the aggregate
sS
loss follows a normal distribution with mean mS and standard deviation s S .)
Then:
m m
P = F k S - F -k S
s S s S
m m
= F k S - 1 - F k S
s S sS
m
= 2F k S - 1
sS
Rearranging:
m 1+ P
Fk S =
s S 2
so that:
1+ P m
F( y ) = where y = k S .
2 s S

Page 54 ST8-18: Credibility theory
Solution 18.8
We use the standard results for the mean and variance of a compound Poisson
distribution.
Recall from Subject CT6 that the mean and variance of a compound distribution are:
E ( S ) = E ( N )E( X )
and
var( S ) = E ( N )var( X ) + var( N )[ E ( X )]2
(We are assuming that claim numbers and amounts are independent.)
Given m N = nS is the expected number of claims for aggregate losses, then:
mS = m N m X = nS m X
and:
s S2 = m N s X2 + s N2 m X2
Substituting for mS and s S in equation (18.9) gives:

nS m X
y =k
1
(
m N s X2 + s N2 m X2 ) 2

Solving for nS (and using m N = nS ):
2
y m s +s m
2 2 2
nS = N X 2 N X
k mN m X
2
y s s2
2
= N + X2
k mN m X

ST8-19: Actuarial investigations Page 22a
There are many reasons why an insurer would want to monitor its portfolio movements;
most notably to manage
volume and mix of business
cross-subsidies, and
growth of the business.
Volume and mix of business
Expense assumptions will be based on an expected range of business volumes.
This is because the insurer will need to cover a specified amount of fixed expenses and
will include a fixed loading per policy in the premium so that each policy contributes to
the overall fixed costs.
If more or less business is written than expected (or the mix of new and renewal
business in the portfolio changes), the unit cost may be higher, either because
the fixed expenses are spread over a smaller base or because of overtime
payments and so on.
As noted in Section 2, it generally costs more to write a new policy than to renew an
existing policy and so a higher proportion of new business will lead to higher expenses
overall.
The business may be written unevenly so that there are concentrations of risk.
This reduction in the diversification of the business will increase the risk to the
business.
It is therefore crucial to monitor any potential accumulations of risk.
Cross-subsidy
The rates charged will often include an element of cross-subsidy between

different parts of the portfolio or different products. If this is well-managed, such
cross-subsidies can improve the overall profitability or assist the meeting of
growth targets. However, if the mix of business does not follow the expected
pattern the business may end up with a substantial amount of unprofitable
business.

Page 22b ST8-19: Actuarial investigations
Growth of the business
A company may wish to grow its business, either by extending existing coverage
to new groups (for example, extending travel insurance to older age groups) or
by writing entirely new products. To do this, the company must make a large
number of assumptions, and there may be little appropriate data to help it.
Possible data sources include industry data, population statistics, data from
reinsurance companies and data from similar products in other territories.
This lack of good-quality data means that there may be a lot of uncertainty in the
premium rates charged.
There are risks that the resulting business volumes will differ from those
expected, and that the claims experience will be worse than anticipated.

ST8: Q&A Bank Part 5 Solutions Page 3
Taking logs gives:
ln L(l ) = ln C - 3l + ln l n1 + n2 = ln C - 3l + (n1 + n2 ) ln l [1]
Differentiating and setting the derivative equal to zero gives:
d n +n n +n
ln L(l ) = -3 + 1 2 = 0 l = 1 2 [1]
dl l 3
Checking whether we have a maximum
d 2 ln L (n1 + n2 )
2
=- < 0 max []
dl l2
[Maximum 3]
(ii)(a) Posterior distribution
1
Since the prior distribution for l is exponential with mean , the prior pdf is n e -nl .
n
So we have:
post pdf e -nl e -3l l n1 + n2 = l n1 + n2 e - (3+n ) l . []
Comparing this to the standard distributions given in the Tables, we can see that this is
the PDF of a gamma distribution with parameters a = n1 + n2 + 1 and d = 3 +n . Hence
the posterior distribution is gamma (n1 + n2 + 1,3 + n ) . [1]
(ii)(b) Credibility estimate
The mean of the posterior distribution is:
n1 + n2 + 1
[1]
3 +n
This can be written in the form:
3 n +n n 1 3 n +n 3 1
1 2+ = 1 2 + 1 - [1]
3 +n 3 3 +n n 3 +n 3 3 +n n

Page 4 ST8: Q&A Bank Part 5 Solutions
3
This is in the form of a credibility estimate with credibility factor Z = . []
3 +n
[Total 4]
Solution 5.5
1 + P 1.93
F ( y) = = = 0.965 .
2 2
So y = 1.81195 . [1]
y2
The standard for full credibility for severity is n X = nN CVX2 where nN = and where
k2
sX
CVX = , giving:
mX
2
y2
s
nX = 2 X
k mX
1.811952 6, 400, 000

= 2

0.05 8002
= 13,133
[2]
[Total 3]
Solution 5.6
(i) Analysis of movement statistics
As an early warning system to spot trends or adverse changes in business written. []
In particular, this will allow the insurer to:

Measure the growth or contraction of parts of the portfolio. This may indicate
that the premium structure is out of line with the rest of the market. []
Get early notice of the growth or contraction of the whole portfolio. This may
indicate that the insurers level of premium rates is out of line with the rest of the
market. []
Measure volumes of business. If more (or less) business is written than
expected, the fixed expenses will be spread over a higher (or lower) base. []

ST8: Q&A Bank Part 5 Solutions Page 5
Measure and manage the mix of business written. For example, due to the
different levels of expenses for new business compared to renewals, a change in
the proportion of new business compared to renewals will have implications for
overall profitability. []
Measure and manage concentrations of risk in a portfolio. In particular, if
volumes are reducing, the level of diversification may also reduce, leading to a
higher concentration of risk. []
Measure and manage cross-subsidies in order to improve overall profitability or
meet growth targets. []
Assess the effects of a new set of rates or a marketing campaign on the
business []
and hence the sensitivity of the portfolio to market influences. []
[Maximum 4]
(ii) Analysis of profitability of business by source
This will help the insurer in its financial planning by:

showing where the better quality, longer-lasting business comes from, ... []
helping the insurer to avoid the less profitable (or unprofitable) sources of
business []
devising incentive schemes or commission terms to retain or attract the more
profitable business and reward better providers [1]
helping it to negotiate reductions in commission payments on less profitable
business []
enabling it to concentrate on selling business through sources with lower
commission (if the quality of such business is not markedly different). []
[Maximum 2]
Solution 5.7
(i) Probability P that the total number of claims falls within 2% of the true value
We have
y2
nN = 8, 000 = , so that y = 1.7889 . [1]
0.022

Page 6 ST8: Q&A Bank Part 5 Solutions
Hence
1+ P
= F( y ) = 0.96318 , and P = 0.92636 . [1]
2
[Total 2]
(ii) Expected number of claims with Poisson claim frequency
Under the new credibility standard, y (as a function of constant P ) will remain
y2 1.78892
unchanged, so that: nN = = = 1, 280 . [1]
0.052 0.052
2
s
We now need to find n X = nN (CVX )
2
= nN X .
mX
100
c (100 - x ) dx = 1 gives c = 0.0002 . [1]

0
100
E (X ) = 0.0002 x (100 - x ) dx
0
100
0.0002 3
= 0.01x 2 - x
3 0
= 100 - 66.67
= 33.33
[1]
and:
100
E X ( ) = 0.0002 x
2 2
(100 - x ) dx
0
100
0.02 3
= x - 0.00005 x 4
3 0
= 6, 666.67 - 5, 000
= 1, 666.67
[1]
Hence
var ( X ) = 1, 666.67 - 33.332 = 555.56 . [1]

ST8: Assignment X1 Solutions Page 9
(ii) Changing from a losses-occurring to a claims-made basis
+ There will be less uncertainty over future claims so reserving may be easier. []
+ In particular, exposure to latent claims will be limited, since if claims are not
reported within the period, then they will not be covered. []
+ Claims will be reported more quickly, since policyholders will have to meet a
deadline if they want their claims to be accepted. []
+ The insurer will be able to determine its profits more quickly. []
+ There will be greater clarity as to which period of insurance cover each claim
relates to. []
+ There will be less scope for expensive legal action between insurers to determine
who is liable for any particular claim. []
There is a risk that a customer takes out a policy knowing that a claim has
already occurred, with a view to claiming for it. []
This basis is out of line with the rest of the market, which may make the policy
less marketable []
and less well understood, which may lead to customer dissatisfaction. []
Policyholders may face gaps in coverage if they subsequently move from this
insurer back to an insurer that uses a losses-occurring basis, making them
reluctant to buy policies from this insurer in the first place. []
The policy may not meet the needs of the customer, since policyholders may
require cover for latent claims. []
The claims that emerge will be from different periods of exposure. This
introduces heterogeneity and may make it harder to analyse experience. []
Historical development patterns may not be relevant, so reserving may be

harder. []
There may be an increased number of claims reported (as policyholders are more
likely to report claims as soon as they become aware of them) which could
increase claims handling costs. []
[Maximum 6]

Page 9a ST8: Assignment X1 Solutions
This page has been left blank so that you can slot the replacement
pages into your Assignment Solutions.

ST8: Assignment X2 Solutions Page 7
Solution X2.7
Comment
Proposal forms and data issues are discussed in Chapter 10, Data. Some of the
discussion on rating factors in Chapter 3, Insurance products types, will also be
relevant. You need to think quite widely in this question, so make use of any prior
knowledge you have, as well as applying common sense.
(i) Why there are so many questions on motor proposal forms
In order to charge individuals premiums that reflect the risk, data needs to be collected
to define the risk as accurately as possible. []
This will enable a better classification of risk when calculating premiums. []
The risks faced by an insurer are:

how likely the policyholder is to claim, and []
how big each claim will be, on average. []
There are many factors affecting each of these (ie many different risk factors) ... []
... and there are many different causes of claims. []
In practice, many of the risk factors may be difficult to measure and verify, so
information is collected on various rating factors instead, to use as proxies for the risk
factors. [1]
For example, how good a driver is might be indicated by a combination of: age,
number of years driving experience, recent experience, occupation, convictions, etc. [1]
Other reasons include:

high variability in risk levels []
insurers collect data for rating factors that they are not currently using. []
market practice potential customers seem willing to answer a large number of
questions, particularly if they think this may entitle them to a cheaper price [1]
the method of sale, eg internet or telephone, may enable many questions to be
answered relatively quickly. [1]
Information is also collected for marketing purposes. []

[Maximum 7]

Page 8 ST8: Assignment X2 Solutions
(ii) How to reduce the amount of data
The first possibility is to investigate claims experience carefully and decide which, if
any, rating factors can be removed. Some of the rating factors may be proved to have
negligible impact on the level of risk. [1]
This approach may still lead to problems if the companys rating structure is very
different from the rest of the market, due to the risk of selection. []
Other possibilities are to:

offer insurance to niche groups that can be defined by fewer rating factors []
use external data that can be linked to the data already provided by the
policyholder, eg census data can be linked to the policyholders postcode. []
automatically decline to quote for anything except standard risks. []
[Maximum 2]

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