7. (7 points) XYZ Life produces value-based financial statements.
You are given:
• The hurdle rate is 12%.
• The risk-free rate of return is 4.0%.
• The inflation rate is 1.5%.
• Beta is 2.0.
(a) (1 point) Describe the CAPM formula and calculate the implied rate of return on
average equity investments.
(b) (2 points) Describe validation techniques used to evaluate the accuracy and
reliability of model office projections used in value-based financial analysis.
(c) (4 points) ABC Life offers the same term life insurance product as XYZ. XYZ’s
premiums are 5% higher than ABC’s. Both companies have the same inflation,
investment and hurdle rates.
XYZ has priced the product to achieve an IRR of 13%.
(i) Compare first year earnings for XYZ for the following reporting methods.
• US GAAP,
• Value-based financial reporting, and
• Level ROE financial reporting.
(ii) Determine which company would report higher first year earnings under
each of the reporting methods. Justify your answer.
Course 8I: Fall 2005 -8- GO ON TO NEXT PAGE
Individual Insurance – U.S.
Morning Session
8. (4 points) Senior management would like to introduce a commission schedule that
eliminates vesting entirely. In return, agents will be paid higher commissions. Currently,
all commissions vest to agents at the time of a sale.
You are given:
Current renewal commission scale:
t 1 2 3
rt 3% 3% 3%
Ot 0 0 0
Pt 1.0 0.90 0.80
Proposed renewal commission scale:
t 1 2 3
rt 5% 5% 5%
Ot 0 0.05 0.10
Pt 1.0 0.95 0.90
where:
t = policy year
r = commissions as a percent of the gross annual premium
Ot = probability that premium on new business is written by agents who leave
before business enters policy year t
Pt = probability that the annual premium for the policy year t will be paid
• The discount rate is 3%.
• Expected sales under current compensation scale are $10.0 million of premium.
• Expected sales under proposed compensation scale are $10.5 million of premium.
• Expected expenses excluding commissions are 10% of premium.
Select the commission schedule that produces the highest net revenue for the company.
Show all work.
Course 8I: Fall 2005 -9- STOP
Individual Insurance – U.S.
Morning Session
9. (4 points) ABC Life is concerned about the trend of its fixed annuity sales relative to the
rest of the industry.
(a) Describe available sources of data that may be used to evaluate the trend in fixed
annuity sales.
(b) Describe issues for ABC to consider in deciding whether to withdraw from the
fixed annuity market.
**END OF EXAMINATION**
MORNING SESSION
Course 8I: Fall 2005 -1- GO ON TO NEXT PAGE
Individual Insurance – U.S.
Afternoon Session
**BEGINNING OF EXAMINATION 8**
INDIVIDUAL INSURANCE – U.S.
AFTERNOON SESSION
Beginning with question 10
Question 10 pertains to the Case Study
10. (4 points) Mercury Life plans to enter the individual term life insurance market using a
brokerage distribution system.
(a) Assess this plan in relation to Mercury’s strengths and weaknesses.
(b) Assuming Mercury’s goal is to increase market share through broker
relationships:
(i) Determine the appropriate pricing objective.
(ii) Describe the advantages and disadvantages of this objective.
(c) Assuming Mercury’s goal is to increase market share through consumer
relationships:
(i) Determine the appropriate pricing objective.
(ii) Describe the advantages and disadvantages of this objective.
Course 8I: Fall 2005 -2- GO ON TO NEXT PAGE
Individual Insurance – U.S.
Afternoon Session
11. (6 points) Your company is proposing to sell a block of life insurance business to another
company.
(a) Describe factors to consider before deciding to sell the block.
(b) Explain reinsurance structures available to facilitate the sale of a block of life
insurance business.
(c) Describe goodwill and explain its impact on the transaction.
Course 8I: Fall 2005 -3- GO ON TO NEXT PAGE
Individual Insurance – U.S.
Afternoon Session
Question 12 pertains to the Case Study.
12. (8 points) You are given the following information with respect to Saturn Life’s term
insurance financial statements:
• Saturn uses the same definition of GAAP free cash flow and GAAP surplus as found
in TSA 38 Strategic Management of Life Insurance Company Surplus.
• Solvency-based reserves are equal to GAAP income-based reserves.
• After-tax investment income on required capital for 2003 is $2,750,000.
(a) With respect to annual GAAP ROE:
(i) Explain possible reasons for a non-level pattern.
(ii) Explain possible reasons a particular year differs from the pricing ROI.
(b) Calculate Saturn’s 2003 GAAP free cash flow. Show all work.
(c) Saturn is considering a change to YRT reinsurance from the existing coinsurance
arrangement.
You are given the following information:
• The YRT reinsurance is on a 90% quota share basis.
• The average YRT reinsurance premium on 2003 issues is $0.55 per $1000.
• Average first year mean reserve credit on YRT reinsurance is $0.60 per
$1000.
• Average first year mean reserve credit on coinsurance is $0.71 per $1000.
• There were no deaths on contracts issued in 2003.
Revise the 2003 pre-tax shareholder earnings assuming term policies sold in 2003
are reinsured under the YRT arrangement, ignoring any impact on DAC and
investment income. Show all work.
Course 8I: Fall 2005 -4- GO ON TO NEXT PAGE
Individual Insurance – U.S.
Afternoon Session