Ca1 Pu 11

CA1: CMP Upgrade 2010/11 Page 1
The Actuarial Education Company IFE: 2011 Examinations

Subject CA1

CMP Upgrade 2010/11

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 2010 study material to
make it suitable for study for the 2011 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 2011 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 2011 exams.

Page 2 CA1: CMP Upgrade 2010/11

IFE: 2011 Examinations The Actuarial Education Company
1 Changes to the Syllabus objectives and Core Reading

1.1 Syllabus objectives

No changes have been made to the syllabus objectives.

1.2 Core Reading

Chapter 1

Page 4

The following bullet point has been added to the Core Reading at the top of page 4:

advise on reinsurance and other risk transfer mechanisms

Page 7

The first sentence of the third paragraph of Core Reading has been amended slightly to
say:

Professional skills and detailed consideration of The Actuaries Code are
covered in detail in a two-day post-qualification course, and actuaries subject to
the Continuing Professional Development scheme are required to keep their
professional as well as their technical skills up to date.

Page 8

Core Reading has been added to Section 3.2 on technical and ethical standards.
Replacement pages 7 and 8 are attached.

Chapter 2

Page 9

The final bullet point at the bottom of page 9 has been deleted from the Core Reading.

Chapter 5

Page 10

The third paragraph of Core Reading in Section 7.2 has been amended slightly to say:

A future need may be one that relates to a customers future aspirations, for
example to retire at age 55 or to pay off a mortgage at a particular date.

Chapter 6

Page 16

The second bullet point of Core Reading has been amended slightly to say:

a desire to look after employees and their dependants financially beyond
the level provided by the State

The Core Reading sentence immediately above Question 6.7 has been amended to say:
UK surveys indicate that the second point above is the main reason for financing
benefits for employees.

Chapter 36

Page 11

The first definition of fair value has been amended to say:

1. the amount for which an asset could be exchanged or a liability settled
between knowledgeable, willing parties in an arms length transaction

Chapter 37

Page 12

The fourth Core Reading bullet point has been amended to say:

increase in the past service liabilities over the year


The sixth Core Reading bullet point has been amended to say:

surplus / deficit

Chapter 38

Page 29

In the fourth paragraph of Solution 2, the second sentence has been slightly amended to
say:

It may be better to have a scheme doctor but then there will be additional costs
involved.

Chapter 39

Pages 10 and 11

The Core Reading for Section 3, which discusses liquidity risk, has been significantly
re-written. You should remove pages 9 to 11 and replace them with pages 9, 10, 11a,
11b, 11c and 12 attached.

Chapter 41

Page 7

The Key Information sentence has been slightly amended to say:

Insurers and reinsurers take on risks in return for a premium because in doing
so they can combine or pool many risks together, which means that there is
greater certainty in the future payments they are likely to have to make on the
occurrence of an insured event.

Chapter 43

Page 7

The first sentence of Section 4.1 has been slightly amended to say:

Scenario analysis is a means of evaluating risk where a full mathematical model
is inappropriate.

Chapter 47

Page 9

The first sentence of Core Reading has been slightly amended to say:

The Solvency II regime is still under development and is unlikely to be required
in the UK until 2013 at the earliest


2 Changes to the ActEd Course Notes

Chapter 1

Page 7

The first sentence in the second paragraph of Section 3.1 on professional conduct
standards has been amended to say:

The Actuaries Code came into force on 1 October 2009.

Page 8

Explanations have been added to Section 3.2 on technical and ethical standards,
following additions to the Core Reading.

Replacement pages 7 and 8 are attached.

Page 17

A sentence has been added at the bottom of the first page of the Chapter 1 Summary,
which says:

The Board for Actuarial Standards (BAS) is responsible for technical standards. BAS
issues Guidance Notes and Technical Actuarial Standards (TASs).

Page 21

The first sentence to solution 1.2 has been amended to say:

Risks assess, quantify and manage them; advise on risk transfer mechanisms.

Chapter 2

Page 20

The final sub-bullet point of the first list on page 20 has been deleted, following
deletion of the Core Reading.

Chapter 5

Page 2

The second sub-bullet point has been amended slightly to:

insurance products and pensions: http://www.thisismoney.com and
http://www.moneymadeclear.org.uk.

Chapter 19

Page 4

The second sentence of the example has been amended slightly to say:

In 1992, it reached more than $2 at its peak, but then within 6 months lost more than
25% of its value against the $ following Black Wednesday (and the leaving the
European Exchange Rate Mechanism).

Chapter 20

Page 11

The following question has been added before the final paragraph:

Question

Explain the term purchasing power parity in the previous paragraph.

Solution

The purchasing power parity exchange rate is the exchange rate that allows us to buy
the same basket of goods in different countries of the world. For example, if the PPP
rate is 1 =$1.50, then we should be able to buy the same basket of goods with 100 in
the UK as with $150 in the US.

The PPP theory says that if the price of goods changes in one country, then nominal
exchange rates will adjust so that real exchange rates stay the same.


Chapter 24

Page 7

An example has been added after the Core Reading explanation of the yield gap:

Example

In the UK, relative running yields on investments would historically have performed as
follows:

GRY on bonds >rental yield on property >gross dividend yield on equity.

From the 1950s to 2008, the yield gap was always negative except for a few weeks in
2003. However, during the economic uncertainty that followed 2008, the yield gap has
been much more volatile.

Chapter 34

Page 14

The first paragraph of the example has been amended to say:

In the UK there is a Financial Services Compensation Scheme (FSCS). Policyholders
are eligible for protection under this scheme if they are insured by an authorised
insurance company and that company is unable to meet its liabilities. Under the
scheme, compulsory insurance claims (eg third party motor insurance and employers
liability) are paid in full. For other insurance claims, 90% of the claim amount is paid.

Chapter 35

Page 35

The fifth sub-bullet has been slightly amended to say:

any prescribed methods / assumptions to be followed.

Chapter 36

Page 22

Following a change to the Core Reading, the first definition of fair value has been
amended to say:

1. the amount for which an asset could be exchanged or a liability settled between
knowledgeable, willing parties in an arms length transaction

Chapter 39

Pages 10 and 11

Explanations of the new Core Reading on liquidity risk have been added. You should
remove pages 9 to 11 and replace them with pages 9, 10, 11a, 11b, 11c and 12 attached.

Chapter 47

Page 9

The final paragraph has been deleted and replaced with:

The MCR will be calculated using a simple factor-based formula which is intended to
be roughly 30% to 40% of the SCR.

3 Changes to the Q&A Bank

Part 1

The following points have been added to the solution of Question 1.18:

The BAS also issues Technical Actuarial Standards (TASs). These can be on either
specific or generic topics. []

Actuaries may only depart from these standards if the departure is not considered to be
material. []

The following rows have been added to the table in Section 3:

Paper Exam sitting Question No. Chapter(s) Marks
1 September 2009 3 2 10
1 September 2009 7 1 22
1 April 2010 2 6 10
2 April 2010 1 1 9
2 April 2010 6 3 16
2 April 2010 7(i), (ii) 1 14

Part 2


1 April 2010 3(i) and (ii) 9 9
2 April 2010 6 7 16
2 April 2010 7 8 28

Part 3


1 September 2009 6 14 25
2 September 2009 7 12 27
1 April 2010 3(iii) 12 5
1 April 2010 4 13, 14, 15 17
1 April 2010 5 13, 14, 15 22

Part 4


1 April 2010 4 16, 17, 18, 19 17
1 April 2010 5(v) 17 2

Part 5

The second sentence of Question 5.10 has been replaced with:

The rent cannot be changed until the lease with the current tenant expires, three years
from now.

The final sentence of Question 5.10 has been replaced with:

State any further assumptions you make and indicate the most important aspects of
uncertainty in your valuation of the office.

The solution to Question 5.10 has been significantly re-written and corrected You
should remove pages 9 and 10 and replace them with pages 9, 10a, 10b attached.



2 September 2009 1 21 4
2 September 2009 2 20, 22 5
2 September 2009 6 20 20
2 April 2010 2 23 9

Part 6


1 April 2010 4(ii), (iii) 26 12
1 April 2010 5(vi) 28 4

Part 7


1 September 2009 4 30 14
1 September 2009 7 30 22
2 September 2009 7 29 27
1 April 2010 1 29 5
1 April 2010 6(ii)-(iv) 30 10

Part 8


1 September 2009 1 34 5
1 September 2009 5 35 16
2 September 2009 4 38 13
1 April 2010 6(i), (vi), (vii) 38 16
2 April 2010 5 34, 38 14

Part 9


1 September 2009 2 41 8
1 September 2009 3 39 10
1 September 2009 7 42 22
2 September 2009 3 39 13
2 September 2009 5 39, 42 18
2 September 2009 7 43 27
2 April 2010 4 43 12
2 April 2010 5(ii) 40 5
2 April 2010 7 41 28

Part 10

A new question has been added. Please insert pages 33 to 35, which are attached
below.



1 September 2009 2 45 8
1 September 2009 6 46 25
2 September 2009 3 49 13
2 September 2009 5 44, 45 18
2 September 2009 6 46, 47 20
2 September 2009 7 44, 45 27
1 April 2010 6(v) 46 6
2 April 2010 3 47 12
2 April 2010 7 45 28

4 Changes to the X Assignments
Assignment X2

Question X2.7
The first paragraph of the question has been amended slightly to say:
A life insurance company is considering entering the market for long-term care
contracts. The contract will be single premium with cover to commence immediately.
Solution X2.9
The fourth sentence on page 12 has been amended slightly to say:
If a choice of different investment funds is offered under Option 2, this will cater for a
variety of different risk appetites amongst members. []

Assignment X4
Question X4.5
The question has been reworded slightly to say:
You are the manager of a large investment trust company that invests solely in overseas
equities.
Discuss the factors that may influence the asset allocation between different stock
markets. [7]
Solution X4.5
The following section has been added to the solution:
Factors that will influence the companys view of expected returns include:
market expectations of the economic prospects for each territory []
the companys own view of the economic prospects for each territory []
key investment ratios for each market, eg price earnings ratios, dividend yields
etc if available and comparable []
any specific factors which might increase the riskiness of each market,
eg impending general elections. []
Note that the factors that influence the expectation of returns in each market will
become clearer after reading the next part of the course.

Assignment X6

Solution X6.1

The following sentence has been added to the solution:

The accrual of future liabilities may also affect the choice of assets. []

Solution X6.2 (ii)

The following sentence has been added to the bullet points on page 5:

Valuations require expertise and are also very subjective. []

Solution X6.3 (i)

The following points have been added to the bullet points on page 6:

potential for higher returns, eg
assets may be bought cheap, ie at a discount to net asset value (NAV) []
the discount to NAV may narrow, which would enhance returns []

Assignment X8

Question X8.2

The second bullet point of this question has been amended to:

500,000 currency units, to be revalued in line with inflation.

Solution X8.2

Additions have been made to this solution so that the final five paragraphs say:

For example, the appropriate excess of assets might be set to reflect:
the types of insurance sold (ie how uncertain) []
the insurers strength of basis []
the insurance risk management activities []
the level of reinsurance taken out. []
[ for each suitable example, maximum 1]
The purpose of the 500,000 currency unit minimum is to ensure that small insurers have
to hold at least a certain minimum amount of free assets. This seems a sensible measure
since a small insurer is less able to cope with volatility in experience. [1]

However, there could also be restrictions on the type of assets used, eg to ensure that
the margin is held in liquid, stable assets. []

A decision needs to be made as to whether 500,000 currency units is a sensible level,
and whether the amount should vary by the type of business written. [1]

Consider the approach adopted in other countries. []
[Maximum 14]

Solution X8.3


There may be also be tax implications, eg a more prudent basis would defer the
sponsors profit, and therefore defer its tax liabilities. []

Solution X8.5 (i)

The solution to part (i) has now reads:

(i) Reasons for maintaining solvency capital

The solvency capital provides an additional level of protection to the customer over and
above that provided by the individual provisions alone. [1]

The objective is to reduce the likelihood of the financial provider becoming insolvent in
reasonably foreseeable circumstances. [1]

It should also help increase confidence in the industry and therefore help prevent
systemic collapse. [1]

If the provider is unable to meet the solvency capital requirements of the supervisory
authority, this may trigger intervention by the authority and a subsequent examination
of how the practices of the provider can be changed to ensure more prudent financial
management and to safeguard the benefits of the customers. [1]
[Maximum 3]

Solution X8.6

The solution has been amended. Replacement pages 7 and 8 are attached.

Solution X8.9


introducing programmes to encourage health and safety at work []

Assignment X9

Question X9.1

Part (ii) of this question has been amended to say:

(ii) List the most important rating factors for pricing:
(a) a critical illness contract
(b) an employers liability contract. [6]
[Total 9]
Solution X9.1

The solution to part (ii) has been amended slightly to say:

(ii)(a) Rating factors for a critical illness contract

sex of applicant
age of applicant
smoker status of applicant
level of sum assured
occupation of applicant
height and weight of applicant
medical history of applicant / family of applicant
[ each, maximum 3]

(ii)(b) Rating factors for an employers liability contract

type of industry or occupation
number of employees
average salary
sum assured (or other exposure measure)
previous claims experience
location of the workforce
the materials handled or processes involved
the extent of safety / first aid standards in place
[ each, maximum 3]

Solution X9.2

Several points have been added to Solution X9.2, which now reads:

General point

Whilst the insurer can allow for the expected effect of selective withdrawals in pricing
the contracts or in the terms it offers on withdrawal []

it may not make sufficient allowance. []

(a) Term assurance

There is a risk of selective withdrawals on:
regular premium policies (which are lapsed, ie where premiums cease to be
paid) []
single premium policies where a surrender benefit is offered. []

The risk is that those in better than average health withdraw. []

The average mortality of the remaining policyholders could be significantly heavier as a
result. []

By offering a surrender value, the insurer would significantly increase the risk of
withdrawals (particularly of healthier lives). []


This might be a more significant problem towards the end of the contract, so the insurer
should consider offering a relatively low surrender value towards the end of the term.
[]

(b) Immediate annuity

Selective withdrawals represent a risk only if the insurer provides a surrender benefit on
withdrawal. []

The risk would be that those in worse than average health withdraw. []

The company is at risk of making a lump sum surrender payment to a policyholder who
was about to stop receiving payments altogether (through death). []

The average mortality of the remaining annuitants could be significantly lighter as a
result. []

For these reasons, it is very unusual to offer a surrender benefit from an immediate
annuity contract and the insurer should think very hard before offering such a benefit.
[]

(c) Endowment assurance

The risk is that those in better health than average withdraw. []

However, since an endowment assurance is primarily a savings contract, the risk may
not be a serious worry in practice. []

The extent of the risk may depend on how the benefit on death compares with the
benefit on maturity. The larger the former relative to the latter, the greater the risk. [1]

In practice, the insurer is likely to offer a surrender value on endowment business, and
selective withdrawals will not pose a very significant risk. []
[Maximum 6]

Solution X9.6(ii)

The following point has been added under the second bullet point on page 9:

an increase in morbidity, so that more people require treatment []

Solution X9.9(iii)

The fifth and sixth points of part (iii) have been corrected to say:

The fire risk and business interruption risk could be covered through insurance ... []

... again at a cost since the premiums will contain loadings for the insurers profit and
expenses. []

Assignment X10

Solution X10.3(ii)(b)

The second paragraph of part (ii)(b) has been amended to say:

So the insurer would need proportional insurance whereby the proportion reinsured for
each individual risk is determined by the size of that risk (which is likely to vary for
each different building). [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 CA1:
Series Y Assignments
ASET (ActEd Solutions with Exam Technique) and Mini-ASET
CA1 Bitesize
Flashcards
Mock Exam A and Mock Exam B
Revision Notes
Smart Revise
Sound Revision.

For further details on ActEds study materials, please refer to the 2011 Student
Brochure, which is available from the ActEd website at www.ActEd.co.uk.

5.2 Tutorials

We offer the following tutorials in Subject CA1:
a set of Regular Tutorials (lasting three full days)
a Block Tutorial (lasting three full days)
a Revision Day (lasting one full day)

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 2011 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 CA1@bpp.com
or by fax to 01235 550085.

CA1-01: How to do a professional job Page 7
3 The professional framework of the Actuarial Profession
The professional framework of the UK actuarial profession comprises both
ethical or conduct standards and technical or practice standards.
3.1 Professional conduct standards
The Faculty and Institute of Actuaries requirements are set out in The Actuaries
Code. Detailed knowledge of The Actuaries Code is not required for
examination purposes, but all actuaries should be aware of the issues that are
addressed in The Actuaries Code, and be aware how to access it.
The Actuaries Code came into force on 1 October 2009. The code is structured around
the following five principles:
integrity
competence and care
impartiality
compliance
openness.
The Actuaries Code will from part of a new Actuarial Profession Standards framework
comprising of:
The Actuaries Code
Actuarial Profession Standards (AP Standards)
Information and Assistance Notes (IANs).
Further details on the new framework can be found on the Institute and Faculty of
Actuaries website: www.actuaries.org.uk.
Professional skills and detailed consideration of The Actuaries Code are
covered in detail in a two-day post-qualification course, and actuaries subject to
the Continuing Professional Development scheme are required to keep their
professional as well as their technical skills up to date.
For most actuaries subject to the scheme this includes spending at least 2 hours every
year developing professionalism skills and attending a one-day professionalism event at
least once every 10 years.
Page 8 CA1-01: How to do a professional job
Professionalism is essential in setting the scene for the context in which the
actuary will operate. The basic principles of professionalism will determine the
suitability of solutions to the problems raised. A reading of The Actuaries Code
is therefore likely to aid in the consideration of the solution to any actuarial
problem.

3.2 Technical and ethical standards
These are set out in Guidance Notes that set out technical or ethical best
practice and standards for actuaries to follow. The technical Guidance Notes are
set by the Board for Actuarial Standards and the ethical guidance notes are set
by the Actuarial Profession. Knowledge of the technical content of Guidance
Notes is not required until the Specialist Application Subjects.

In the UK, the majority of the Guidance Notes relate to actuarial technical
standards, and are the primary responsibility of the Board for Actuarial
Standards (BAS). This is a body that is independent from the Actuarial
Profession, and reports ultimately to the Financial Reporting Council. The
Actuarial Profession remains responsible for ethical standards, and thus retains
responsibility for the relevant Guidance Notes.

The BAS issues Technical Actuarial Standards (TASs). The aim of the TASs is to
ensure that users of actuarial information can have confidence in the
informations relevance, transparency of assumptions, completeness and
comprehensibility

TASs are issued on either specific or generic topics. The specific topics include
areas such as insurance or pensions. The generic standards apply to all areas
of actuarial work.

Three generic TASs have been written covering data, reporting and modelling.

The TASs are developed in the context of UK legislation and regulations. They
apply to work done in relation to the UK operations of entities and any non-UK
operations which report in to the UK. However, for the Generic TASs wider
adoption is encouraged by BAS.

Work may depart from the requirements of a TAS if the departure is considered
not to be material. In this context, something is material if, at the time the work
is performed, the effect of the departure (or the combined effect if there is more
than one departure) could influence the decisions to be taken by the users of the
resulting actuarial information.

More information about the BAS can be found on its website, at www.frc.org.uk/bas.
CA1-39: Sources of risk Page 9
Rating agencies (eg Moodys and Standard and Poors) are specialised independent
companies focussed on the provision of high quality, objective credit analysis. They
assess, for example, the relative quality of tradable bonds. Each agency has its own
classification of ratings, for example:
Moodys Standard and Poors
Aaa
Aa
A
Baa
AAA
AA
A
BBB
Investment
Grade
Ba
B
Caa
Ca
C
BB
B
CCC
CC
C
Junk Bonds
A company may take action to improve its credit rating and these actions may
affect the market for that companys and other companies shares.
Page 10 CA1-39: Sources of risk
3 Liquidity risk
3.1 Individual or company liquidity risk
The normal definition of liquidity risk relates to individuals or companies.
Liquidity risk is the risk that the individual or company, although solvent, does
not have available sufficient financial resources to enable it to meet its
obligations as they fall due, or can secure such resources only at excessive cost.

Liquidity risk for non-financial institutions

Liquidity pressures are the most common reason why a trading company goes
into liquidation. The phrase into liquidation immediately gives the reason for
the action.

A trading company may well have sufficient assets, probably largely stock and
work in progress, to cover its liabilities, but if those assets cannot be realised,
then the company may not be able to satisfy its creditors, who can force it into
liquidation, and possibly to cease trading.

Liquidity risk for insurance companies and benefit schemes

Insurance companies and benefit schemes normally have little exposure to
liquidity risk, because a large proportion of their assets are in cash deposits or
bond and stock market assets. In general, these can readily be sold in the
market to raise cash when required.

General insurers face liquidity risk if claim costs are higher than expected, for example
in the event of a catastrophe.

A benefit scheme may face liquidity risk in the event of a bulk transfer out of the
scheme.

Liquidity risk for banks

Banks are generally exposed to significant liquidity risk. They lend depositors
funds and funds raised from money markets to other organisations, and
generally do so for longer periods than they offer to the providers of the funds.

A retail bank that offers customers instant access to their deposits needs to
maintain sufficient liquid resources to withstand a large number of customers
asking for their money back.

For this reason banks frequently offer good investment returns on fixed term
deposits, where the depositors are not able to access their funds until the
maturity date.
CA1-39: Sources of risk Page 11a
So banks face liquidity risk if more customers than expected demand cash, ie withdraw
their deposits.

Liquidity risk for collective investment schemes

Similarly, collective investment schemes and insurance funds that invest in real
property need to protect themselves if clients request access to their funds when
the underlying properties cannot be sold. Such funds frequently have the power
to defer withdrawals by up to six months if necessary, to allow time for property
sales. Hedge funds that invest in illiquid assets also often have lock-in periods
to mitigate liquidity risk.

The reference to insurance funds here means that unit trusts face liquidity risk if more
policyholders than expected surrender their policies.

Similarly, collective investment schemes face liquidity risk if more customers than
expected wish to sell their units.

Managing liquidity risk

Financial companies will maintain a degree of liquidity to deal with anticipated liability
withdrawals. In the event of these withdrawals being greater than expected, the
company may have to convert some of its less liquid assets to cash or else try to borrow
additional funds (which may be unavailable or expensive).

Financial companies can allow for liquidity risk to some extent, by allowing a margin
for withdrawals being higher than they expect and by allowing for predictable seasonal
variations (eg higher bank withdrawals pre-Christmas). Typically, the biggest liquidity
risk issues for a financial company arise as a result of a sudden surge in liability
withdrawals.

Question 39.6
Why might there be a sudden surge in customers withdrawing their deposits from a
bank?

Page 11b CA1-39: Sources of risk
3.2 Market liquidity risk
In the context of the financial markets, liquidity risk is where a market does not
have the capacity to handle (at least, without a potential adverse impact on the
price) the volume of an asset to be bought or sold at the time when the deal is
required. In general, the larger a market is, the more liquid it will be, because
more participants in the market will be trading at any one time. Thus when any
member of the market wishes to complete a trade, it is likely that the market will
be able to find a counterparty willing to accept the trader. This particular
definition of liquidity is frequently also called marketability.

Even in small illiquid markets, there is a reasonable probability of being able to
find a counterparty for any desired transaction. The key phrase in the definition
above is without a potential adverse impact on the price . For example,
specialist firms are frequently prepared to purchase residential property
immediately, but at a large discount to the market value. Because these firms
exist, residential property could be described as a marketable asset, but not a
liquid one, because of the adverse impact of a forced sale on the price.

Key information

In some cases it is important to distinguish liquidity from marketability:
Marketability is how easy it is to convert an asset into cash.
Liquidity is a measure of how long it will take for an asset to become cash.

A highly liquid asset therefore has two characteristics:

1. It either will quickly become cash because of the terms of the asset itself (eg a
short-term bank deposit or a government bond with one week until redemption)
or else there is a high degree of certainty that the asset could be sold quickly if
required.

2. The amount of cash it will or could become is (almost) certain.

Marketability considers only the characteristic of how certain it is that an asset can be
sold quickly if required.

CA1-39: Sources of risk Page 11c
Example

A seven day fixed-term deposit at a bank is a highly liquid asset it will become
cash within a week.

However as such deposits cannot be cashed early or assigned to a third party,
they are completely unmarketable.

Page 12 CA1-39: Sources of risk
4 Market risk
Key information
Essentially market risks are the risks related to changes in investment market
values or other features correlated with investment markets, such as interest and
inflation rates.
The risk can be divided into:
the consequences of changes on asset values (this is the most obvious
implication)
the consequence of investment market value changes on liabilities
the consequences of a provider not matching asset and liability
cashflows.
4.1 Asset value changes
Asset value changes can result from:
Changes in the market values of equities and property. These risks can
be systemic if they occur across the whole market under consideration,
but can be diversified in broad markets by holding a range of assets and
asset classes.
Changes in interest and inflation rates. These primarily affect the value of
fixed-interest and index-linked securities, although there is usually a
smaller effect on equities and property.
Question 39.7
Describe the likely effect of an increase in short-term interest rates on the value of:
fixed-interest bonds
index-linked bonds
equities
property.
CA1: Q&A Bank Part 5 Solutions Page 9
Solution 5.8
Advantages of using market price

Easy to obtain for listed shares []
Objective []
Easy to explain to other parties (eg pension fund trustees, directors) []
Realistic (reflects the value you would get if the assets were sold) []

Disadvantages of using market price

Can be extremely volatile, therefore value may vary greatly from day to day []
Market value not available for unlisted shares []
Market value may not reflect circumstances of, and hence the true value of the
share to, the investor (eg tax position and/or liabilities of investor) []
Which market price to use bid price, offer price or mid-market price? []
Market price may not be realisable in practice []
due to dealing costs []
or on sale of a large holding of shares []
May not be consistent with the method and basis used to value any liabilities. []
[Total 6]

Solution 5.9

2
2 3
2
2
(1 ) (1 )
...
1 (1 ) (1 )
(1 ) (1 )
1 ...
(1 ) (1 ) (1 )
1
(1 ) 1
(1 ) (1 )
( )
j
D D g D g
V
i i i
D g g
i i i
D
i v
D
i g
D
i g
+ +
= + + +
+ + +
| | + +
= + + +
|
+ + +
\ .
=
+
=
+ +
=

where:
1 (1 )
(1 ) (1 )
j
g
v
j i
+
= =
+ +
. [2]
Page 10a CA1: Q&A Bank Part 5 Solutions
Assumptions:
g is constant and is an effective rate of dividend growth per annum []
D is the dividend expected in one unit of time from the present []
i is constant, and is an effective rate of interest per annum []
dividends are paid at the end of each unit of time and are annual []
tax and expenses have been ignored []
the share is assumed to be held in perpetuity or is sold at a price consistent with
the formula. []
[Total 5]

Solution 5.10
Market expected inflation is about 3% (5% 2%). []

The easiest way to value this property is to value the first three years rental payments
(until the expiry of the current tenants least), and then value the rack rent in perpetuity,
discounted by a further three years. []

The required return from the property is 8% this is higher than the government bond
yield to cover extra risks such as lack of marketability, voids, depreciation. []

If rental growth is assumed to be 3%, then the rack rental income is effectively a
perpetuity starting in three years time, discounted at
8% 3%
4.854%
1 3%
j
-
= =
+
. [1]

So the present value of the income on the property is:

( )
( )
@8% 3 3 @4.854%
3
3 3
PV 250,000 175,000 1.03 1.08
1
644,274 175,000 1.03 1.08
0.04854
$3,771,640
a a
-
-
= +
= +
=

[1]
This calculation assumes that:
rent is paid annually in arrears []
a new tenant will be found immediately at the end of the current lease []
rent reviews will be conducted annually thereafter. []

Our valuation is therefore around $3.8m, suggesting that $4m is a fair price but slightly
on the high side. []
CA1: Q&A Bank Part 5 Solutions Page 10b
The main aspects of uncertainty are the:
- risk premium required above government bonds []
- assumed future rental growth []
- likelihood of a void from the existing and future tenants and the ease of finding a
replacement (who would be expected to pay rack rent). [1]
[Maximum 6]

This page has been left blank so that you can insert the replacement pages
into you course notes more easily.

CA1: Q&A Bank Part 10 Page 33
Question 10.20
Describe the risk management control cycle. Your answer should include the tools and
techniques you would use at each stage. [13]

Solution 10.20
Risk identification

This is the process of recognising which risks might threaten the income or assets of the
organisation and therefore make it unable to meet its objectives. []

The organisation should ensure it has considered all sources of risk, both financial and
non-financial, eg market risk, liquidity risk, credit risk, operational risk, external risk,
business risk. [1]

Methods that might be used to identify these risks include:
high level analysis to quickly identify significant risks []
brainstorming []
desktop analysis, to research the risks undertaken by similar organisations, and
to obtain the opinion of other experts []
collating the information gathered into a risk matrix or risk register. []

Risk measurement

This is the process of estimating the probability of each risk event occurring, their likely
severities and their interdependence. []

Risks should be quantified by using appropriate risk measures, for example tracking
errors, Value at Risk, expected shortfall, an analysis of actual versus expected
experience etc. [1]

Techniques used to evaluate risks include:
stress testing []
scenario tests []
stochastic modelling. []

Page 34 CA1: Q&A Bank Part 10
Risk control

The organisation should implement measures that aim to reduce the likelihood of an
event occurring or the consequences of risk events. []

The extent to which an organisation controls its risk will depend on:
its risk tolerance level []
the cost / benefit ratio of any control measures. []

Types of risk controls include:
insurance and/or reinsurance []
alternative risk transfer tools []
underwriting []
claims controls []
management control systems, eg contingency planning []
diversification []

Particular care should be taken to control those risks with a significant financial impact
but which have a low probability of occurrence. []

Risk financing

The organisation should hold enough capital to cover the residual risks which remain
after implementing its risk controls. []

This risk capital should allow for:
the interdependencies and accumulations of risk []
the benefits of diversification. []

Tools that may be used to manage the organisations capital include:
equity []
banking products, eg: []
liquidity facilities []
contingent capital []
senior unsecured finance []
derivatives []
subordinated debt []
CA1: Q&A Bank Part 10 Page 35
securitisation []
financial reinsurance []
internal capital management tools, eg: []
merging funds []
changing the asset mix []
weakening the valuation basis []
deferring the distribution of surplus or dividends. []

Risk monitoring

The organisation should review all the identified risks on a regular basis. []

It should also conduct regular overall business reviews to identify new risks, or risks
that were omitted from the previous exercise. []

The organisation should ensure it has sufficient, accurate data in order to be able to:
update assumptions []
monitor any adverse trends so as to take corrective actions []
provide management information. []
[Maximum 13]

This page has been left blank so that you can insert the replacement pages
into you course notes more easily.

CA1: Assignment X8 Solutions Page 7
Solution X8.6
The option terms should be actuarially neutral on a given set of assumptions so the
actuary would need to set up an equation of value equating the two forms of benefit
(pension and lump sum). [1]

Some items of the basis may be problematic to decide, eg the allowance to make for
discretionary increases. []

The actuary needs to consider what type of basis to use, eg a basis stable over time, a
market-related basis or the valuation basis. []

Consider the risk of selection, eg those with worse expected mortality would benefit
from choosing to commute as much as possible of their pension. [1]
Cultural bias will affect how popular the option to take the maximum cash lump sum
will be. []
Often, the option tends to be popular (especially if there are tax advantages) unless
terms offered are particularly poor. []
This reduces the extent to which selection is an issue. [ ]
The level of financial sophistication amongst scheme members will also be considered,
since this will affect the take-up rate. [1]
Future economic conditions are also likely to affect the take-up rate. [ ]
If the scheme sponsor wants to discourage or encourage take up of option the terms
Page 8 CA1: Assignment X8 Solutions
Regulation may impact on the terms, for example: []
prescribed terms
requirement for unisex terms
limits on amounts that can be commuted. [ for a suitable example]
The scheme rules may require certain terms to be applied []
or there may be existing industry custom and practice or competitive pressures,
which influence the terms. []
There may be liquidity issues (which may affect the asset mix), eg if many people
decide to take the cash. []
The terms for commutation should be reviewed on an ongoing basis. []
[Maximum 9]

Solution X8.7
(i) Setting the terms for the option and valuing it

General principles

A starting principle is usually that a scheme should suffer neither profit nor loss if the
option is exercised, ie that the terms for the option are actuarially neutral. [1]

This will require an equation of value to be set up between the two sets of benefits being
exchanged. []

The option will need to be revalued periodically to reflect changes in the key
assumptions. []

Mortality assumptions and selection

There is a risk of selection against the sponsor []
that the option is exercised by members in poor health []
and/or where dependants are in good health []
and/or where there are young dependants. []
The actuary could allow for the anti-selection by adjusting the mortality rates
accordingly []

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